The second part observes problems inflicted to the eurozone economies from overseas. It then talks about how international capital inflows (due to large CA deficits shown in part 1) were used in local economies. Regarding the existing affairs, the economist offers its short history of the eurozone turmoil, worthy of reading.

In addition, its Free Exchange blog offers two good texts on the current eurozone affairs, one on Spain, the other on Italy. When one country operates a current account deficit, therefore that a surplus is run by it in its capital account. A capital account surplus means an inflow of foreign capital (investments) into a country, which is essentially a good thing since money will always flow to where it expects the best and safest returns.

However, the question is where is the amount of money from overseas being used in domestically? Foreigners with high savings rates (China, Japan, Germany) choose where you can invest their savings, plus they usually choose the united states, regarded as a safe haven for investments due to numerous factors. In Europe, cost savings from the core eurozone countries was channelled to the peripheral countries after presenting the euro, which explains the high CA deficits experienced by all the peripheral countries, described in the previous post. Prior to the euro unification Greece got a previous background of personal debt defaults, financial contagion, inflation crises and banking crises (see Reinhart and Roggof).

This was usually shown in its higher bond yields, a sort of a risk superior for investing in its debt. The spread between Greek and German bonds was always high. However, the euro was introduced once, its yields and the spread started decreasing making the Greek debt as safe an investment (financially) as the German debt.

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The reasoning behind it was that the ECB would make sure inflation won’t again be the issue of Greece or any other peripheral country. Soon enough, every eurozone peripheral relationship on the market traded as the German Bund – the spreads were smaller and the potential risks were perceived as non-existent (Basel I and II regarded their debts as zero risk-weighted property).

This meant one thing; all these countries could borrow at cheap rates, while the politicians had you don’t need to be fiscally accountable and could holiday resort to populist insurance policies that would keep them in power. Borrowing cheaply designed that credit from overseas was used to gas domestic usage which led to a rapid increase in GDP above its potential levels (see graph from last post). The following graphs observe how the inflow of capital was found in the peripheral economies.

It compares growth of usage and investment and authorities expenditures and investment for all the peripheral economies to see what really drove the GDP far above its potential level, and whether the CA deficit was unsustainable. Source: St Louis Fed, FRED economic data. In Ireland they grew right about 2 yrs prior to the crisis simultaneously, when the housing prices started to fall and the building industry started deteriorating – the same effect can be noticed in Spain. Greece, Italy and Portugal saw particularly rising gaps between consumption and investment, implying that a lot more funds were guided into usage than into investment.

The next set of graphs shows the partnership between government expenditures and set capital development. Source: St Louis Fed, FRED financial data. For Greece Even, government expenditure doubled within the last a decade, while its investments rose with a third prior to the crisis, and are getting close to the level these were at a decade back now.

Italy noticed its government expenditures rise the same level as investments, while Portugal experienced a significant loss of the difference between investments and government expenditures after the intro of the euro. Observe also both spikes of investments in Ireland and Spain which show even better on the new group of graphs, directing out to an asset price burst and bubble of the bubble.