Italian and Spanish government bond spreads continue to be high and volatile but have declined sharply compared to the levels reached four months ago. The eurozone is back from the brink of disaster; even so, the fiscal difficulties of Europe’s periphery—dangerous as they are—are only a symptom and not the cause of the crisis.

The periphery is just beginning the process of realignment—away from domestic demand–driven growth and toward the tradable sector—that is needed to deal with the underlying cause of the crisis and will take many years to complete. Some countries may never achieve it and, to return to sustained growth, will be forced to leave the euro.

Spreads Could Easily Surge Again

Key policy steps have reassured markets since Italian and Spanish bond yields hit a peak of 7.5 percent and 6.7 percent, respectively, last November. Most important were the European Central Bank’s two long-term refinancing operations in December and February totaling over a trillion euros, equal to roughly 10 percent of the entire eurozone’s GDP; the restructuring of Greek debt involving a private sector write-off of 105 billion euros and a new cash infusion under a revised European Union/International Monetary Fund program; and new governments in Italy and Spain, which quickly established credibility with the markets by enacting a number of far-reaching austerity and structural reforms.

Luck helped, too, as recent indicators for the United States and China suggest that the global recovery will continue. However, luck can change and steps taken, though necessary, are more palliative than cure—so spreads could surge again.1

To start with, Greece’s debt remains unsustainable, and a second round of restructuring will be needed, this time comprising official debt. Fiscal consolidation is unavoidable, but the question of whether fiscal targets can be met against a background of severe recession and deleveraging, without causing unacceptable social dislocation, remains wide open. And the European Central Bank’s provision of liquidity has shored up banks and supported government bond purchases but does not deal with the quality of assets on the banks’ balance sheets.

Moreover, the periphery’s fiscal stress is not at the root of the euro crisis (see Paradigm Lost). The blatant cooking of the books in Greece that triggered the crisis three years ago gave a hugely misleading signal about the cause of the crisis. Ireland’s debt-to-GDP ratio was almost halved between 1999 and 2007 (from 48 percent to 25 percent) and so was Spain’s (62 percent to 36 percent). These countries’ debt-to-GDP ratios were much lower than Germany’s in 2007; even today, Spain’s debt burden is lower than Germany’s (70 percent versus 82 percent). Portugal is the only member of the periphery in which debt-to-GDP has gone up appreciably, relative to its level at the euro’s inception. The UK—not a eurozone member—is in fiscal straits comparable to many eurozone countries, but it can borrow at record low interest rates.

Nor are weak banking systems the cause of the crisis in the periphery. When the global financial crisis broke, for example, the Italian and Portuguese banking systems were in much better shape than the French, German, or UK banking systems and, unlike the latter, required little or no government support until years had passed.

Rooting Out the Deeper Disease

The focus on spreads diverts attention from the primary cause of the euro crisis, which is a large misalignment of real effective exchange rates in the eurozone. This began in the mid-1990s as nominal exchange rates froze, interest rates converged, and domestic demand growth and inflation in the periphery was more rapid than the core. These developments—combined with inflexible labor and product markets—led to a progressive erosion of competitiveness in the periphery—an outcome reflected in the higher price of non-tradable services and construction relative to exports and import substitutes, rising unit labor costs, and progressive reallocation of the periphery’s production factors toward the non-tradable sector (see Table 1). 2

Decreased Competitiveness in the Periphery
(All figures cumulative)
  Real Domestic Demand Real Effective Exchange Rate Based on Unit Labor Costs in U.S. Dollars Current Account/Share of GDP Exports/Share of GDP
  Percent Growth Percent Growth Percentage Point Change Percentage Point Change
Germany 2.7 -5 9.3 13.5
Netherlands 6.8 12.3 4.8 4.1
GIIPS Average 25.6 19.8 -3.8 -3.3
Greece 34.3 12 -6.7 -2.1
Ireland 42.8 36.6 -5 -17.7
Italy 10.0 19.2 -1.9 1.9
Portugal 6.8 11.4 0.8 3.3
Spain 34.1 19.7 -6 -2.1
Sources: European Commission AMECO database, IMF, Organization for Economic Cooperation and Development (OECD)


Between 1996 and 2007, real exchange rates in the periphery appreciated by 1.1 percent annually, on average. Between 1997 and 2007, housing expenditure as a share of GDP cumulatively increased by 2.7 percentage points in the periphery (excluding Greece for which data is not available prior to 2000), compared to a 2.2 percentage point decline in Germany. Over the same period, exports of goods and services as a share of GDP increased by almost 20 percentage points in Germany, while in the periphery they increased, on average, by less than 3 percentage points.

This shift, in turn, was reflected in large and widening current account deficits in the periphery and surpluses in the core. Between 1997 and 2007, current account deficits as a percent of GDP deteriorated in the periphery by nearly 8 percentage points, while the core’s surplus rose by 0.9 percentage points. 3

Financial markets mistakenly supported the periphery’s domestic demand–based growth model until it became obviously unsustainable. The global financial crisis prompted a reckoning that would have come sooner or later anyway. According to recent analyses, the sudden stop in private capital flows to the periphery was dramatic, especially in Greece and Ireland, which experienced outflows equivalent to 40 percent and 70 percent of 2007 GDP, respectively, from mid-2008 to mid-2011.

All economic actors, not just financial markets, were operating on wrong assumptions, and the effect on economic activity, government accounts, and the banks of the sudden stop was devastating. Among the eurozone’s periphery economies, current account deficits did not narrow correspondingly because the intra-European payment system and rescue programs compensated for it. By contrast, outside the eurozone, countries such as Bulgaria, Latvia, and Lithuania saw rapid and enormous corrections in their external deficits. Being in the eurozone softened the blow for the periphery and has slowed adjustment.

A Long and Winding Road Ahead

The external and internal imbalances in the periphery necessitate a large devaluation. Given the post-2007 plunge in domestic demand, one would have expected to see unit labor cost containment and a shift toward exports. But over three years after the crisis erupted, progress appears remarkably limited (see Table 2 and Chart 1).

Is the Periphery Rebalancing?
(All figures cumulative)
  Real Domestic Demand Real Effective Exchange Rate Based on Unit Labor Costs in U.S. Dollars Current Account/Share of GDP Exports/Share of GDP
  Percent Growth Percent Growth Percentage Point Change Percentage Point Change
Germany 3.3 0.1 -2.4 2.9
Netherlands -7.2 0.6 0.8 8.5
GIIPS Average -11.6 -2.5 3.9 6.4
GIIPS Average minus Ireland -10 0 3.2 1.7
Greece -18.4 2.3 6.0 0.5
Ireland -20.6* -10.9 7.1 25.1
Italy -4.4 2.2 -1.0 -0.1
Portugal -7.2 -0.2 1.5 3.3
Spain -7.6* -4.4 6.2 3.2
*Based on 2007–2010 data
Sources: European Commission AMECO database, IMF, OECD


With the exception of Ireland, large current account deficits remain and the export response has been small (see Charts 2 and 3). The latest data available for Greece, for the first quarter of 2011, shows an 11 percent current account deficit and no export improvement despite an 18.4 percent decline in domestic demand. Except in Ireland, the decline in the real effective exchange rates of the periphery countries—the “internal” devaluation all are looking for—has been very modest.

So even more demand compression is needed, and indeed coming. The European Commission’s latest forecast shows Greece’s economy projected to shrink by an additional 1.6 percentage points in 2012 and both Spain and Italy falling into recession. Yet, Spain’s unemployment rate is already at almost 24 percent, Greece’s is at roughly 21 percent, Portugal’s is at 15 percent, Ireland’s is at almost 15 percent, and Italy’s is at 9.3 percent and rising fast.

With large fiscal contraction in store over the next two years, banks deleveraging, and consumers and investors nervous, there is no possibility of growth coming from domestic demand in the foreseeable future. Will the tradable sector come to the rescue and serve as a new engine of growth?

This appears least likely in Greece because its export sector is small and mostly based on tourism. Unless this situation changes, Greece may have to leave the euro. Portugal is a little better off, with a bigger export sector, but one that confronts low-wage competitors directly.

Ireland has large high-tech exports, amounting to 100 percent of GDP, funded and operated by foreign multinationals. Ireland has a chance of reigniting growth, but may be hit again by large banking losses.

Spain has several competitive international firms and, unlike the other peripheral countries, has maintained its share of world exports over the past decade. But its export sector is small at roughly 26 percent of GDP, its unemployment is extremely high, and required fiscal adjustment is large. Its capacity to steer through more austerity thus remains in question.

Italy has only a slightly larger export base (29 percent), but one that is highly diversified, with exports ranging from precision machinery to luxury footwear and textiles. Though its public debt is bigger, its fiscal and labor market imbalances are not nearly as large as Spain’s. Given its very recent determined policy effort, Italy may eventually be able to count on a trade-led recovery, though it has shown little sign of this so far.

The chances of success increase if eurozone policies and the periphery’s external environment are supportive. That would mean that the European Central Bank’s liquidity injections continue, a much larger European/IMF Stability Facility is established, domestic demand is stimulated in the core of Europe, eurozone inflation is allowed to edge upward, the euro devalues, and global demand accelerates. But the periphery countries cannot count on any of these, adding to the uncertainty.

So, if not by looking at spreads, how will we know the crisis is ending? By seeing a return of sustainable growth and falling unemployment in the periphery. Both remain distant prospects, as countries sluggishly—and reluctantly—shift away from the unsustainable growth model they counted on for almost a decade.

[1]. The Spanish government has openly expressed doubts about meeting fiscal targets. Italy is in a somewhat better position. Still, ten-year bond yields for both countries have recently ticked up to 5.8 and 5.5 percent, respectively—their highest levels since the European Central Bank’s first long-term refinancing operation.

[2]. Other factors contributed to this process, including weak wage-setting institutions in and overly loose monetary policy for the periphery and increased productivity in Germany due, in part, to the hard-won gains of unification.

[3]. The core is defined here as Austria, Belgium, Germany, France, Finland, and the Netherlands. “GIIPS” is the commonly used acronym for “Greece, Ireland, Italy, Portugal and Spain”—the eurozone periphery.