In the years leading up the recent Euro Area sovereign debt crisis, there were large saving imbalances among the euro area periphery countries, i.e., Greece, Portugal, Spain and Ireland. The periphery countries engaged in heavy borrowing from foreign private investors, allowing domestic spending to outpace incomes. The crisis was sparked by a loss of confidence by private investors in periphery countries’ government debt, causing a spike in domestic interest rates. As a result, these periphery countries will likely have to go forward with greatly reduced borrowing from foreign investors and a difficult adjustment that highlights the dangers of imbalances of not only savings, but investment, labor productivity and consumption in the European Monetary Union (EMU).
The seeds of these savings imbalances among the periphery countries were planted by the creating of a common currency area. Before the late 1990s, countries in the euro area periphery faced much higher interest rates than did euro area core countries, such as Germany. However, once the periphery countries joined the monetary union, these countries had access to financing at much lower interest rates than would otherwise have been possible. Investors knew that monetary policy for the region as a whole would be set by the European Central Bank, seen as likely to continue the strong anti-inflation policies of Germany’s central bank. This essentially eliminated the risk that investments in periphery countries’ debt instruments would be eroded by high inflation. Moreover, given the common currency, the possibility of depreciation or devaluation in the periphery countries was eliminated as well. Low interest rates, however, spurred heavy foreign borrowing by both the public and private sectors in the countries now facing debt crises. The problem is that foreign capital was used to support domestic consumption or housing booms rather than productivity-enhancing investments. In sum, heavy foreign...
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