grounds to express the diversity of the various countries in terms of credit risk and the spread was precisely the expression of such diversity: a perfect shadow currency specific for any country, with the spread differentials corresponding to the floating exchange rate between these currencies.
On the side of the real economy several weaknesses were inherited from the period 2000–2007: significant competitiveness gaps–mainly driven by inflation differentials–had accumulated between the various countries. Peripheral countries (less competitive) had therefore begun to experience trade balance deficits, while the opposite happened to the (more competitive) core countries, especially Germany. But we'll see that the “spreads” have expressed much further than the simple recognition of the competitive gaps shown by the imbalances of the trade flows.
These trade imbalances had a financial counterpart in the dysfunctional trend of the loans disbursed by the German banking system to the banks of the peripheral countries, and in the net balances of the European payments system: Target2. This system is primarily a matter of credit risk and of transferring this risk from the private banking system of a country to its national central bank and, hence, to the whole consortium of the central banks of the Euro area. Analysis of the Target2 net balances shows a very clear picture of the Eurozone at the time of the crisis: on the one hand, the core countries (except France) exhibit positive and increasingTarget2 net balances, where the Bundesbank has the lion's share; on the other hand, the periphery and France exhibit increasingly negative Target2 net balances. The extraordinary size of the German positive Target2 net balance (€500 billion at the height of the crisis) can be explained considering that Germany has implemented a typical vendor financing strategy. Until 2011 the German banking system disbursed huge amounts of credit to the peripheral economies; in parallel, the German current account surplus continued to grow (and the deficit of the peripheral countries to deteriorate) because the periphery used a substantial portion of the credit received to import goods produced by German manufacturing.
The crisis has intervened on these financial and commercial relations, fuelling the gap between the economies of the Eurozone. In the case of the peripheral countries the upsurge of the spreads has compromised the strength of the real economy and its potential for development. In fact, higher spreads result in higher financing costs for the manufacturing industry and, like the inflation differentials, entail competitiveness gaps between the Eurozone countries. In the book, this phenomenon has been dubbed financial inflation or spread-rooted inflation. The burden of higher financial expenses brought many companies out of business or, in the best scenario, to cut the costs of labour. The opposite happened to the German industry that has always been able to raise funds at low costs and sell its production at competitive prices. In this way German manufacturing has consolidated its leadership in Europe, even for goods whose production cycle is mature and there is no competitive advantage in terms of technological progress. Significant advantages of the German manufacturing system are also related to a lower hourly labour cost.
Also with regard to the public finances of the member countries, the spread has accelerated profound and fast divergence processes between centre and periphery. In the case of Portugal, Italy, Ireland, Greece and Spain (the so-called PIIGS) the rising nominal interest rates have been immediately reflected onto an increase in the cost of servicing the public debt. Combined with the mentioned problems on the private sector, this led to a deep recession in PIIGS and to an explosion of the public deficits (to face an increased public spending) which put further pressure on sovereign yields.
In the autumn of 2011 another serious problem arose: the banking systems (especially those of peripheral countries exposed to the speculative attacks of the markets) were running out of cash and could not hold out much longer. In this frantic context, the ECB granted two extraordinary three-year loans (LTROs) for over €1000 billion to the banks of the Eurozone.
The ECB's extraordinary liquidity injections have cooled financial markets and dammed the crisis in the periphery. But they have also had a very positive side-effect for the German banking system. In fact, private banks of the periphery have used a large part of the liquidity received by the ECB to settle their debts to the banks of the core countries and to buy sovereign bonds issued by their own state. The inherent contradiction of these dynamics is glaring. On the one hand they have enabled the German banks to mutualise onto the whole Eurosystem their exposure to the private credit risk of the periphery; but on the other hand they have pushed the banks of PIIGS to take on the public debt of their respective governments and the associated sovereign risks, preventing any mutualisation of these risks on the whole Eurozone.
The divergence process has undergone a major reversal with the “anti-spread” shield deployed by the ECB in September 2012. In fact the deployment of the anti-spread shield with the theoretical possibility of unlimited purchases of bonds by the ECB has effectively contributed to interrupting the bearish speculation on government bonds and mitigating the collateral discrimination, stopping some of the phenomena that caused the uncontrolled growth of the spread. In addition, the concomitant influence of the abundant liquidity coming from Japanese and US monetary expansion schemes has favoured a strong demand for government bonds on the secondary markets, causing a spectacular reduction in yields. The ECB role hence had been determining to avoid the final stage of collapse of the Eurozone, but it could never be enough to ensure its definitive stabilisation.
However, the economic and financial crisis has undermined the solidity of the Euro and fed a clash of interests that averts the prospects of a full integration of the member states.
Both the European Monetary Union and the individual countries have deployed a rich and diversified set of measures to counter the crisis. Specific bodies have been established, in the form of two sovereign bail-out funds, to provide financial assistance to the distressed countries, through the disbursement of loans and the support in the placement of government bonds. In exchange for the assistance received, the peripheral countries have had to engage in severe programmes of domestic reforms, imposed by the Troika (i.e. the triad composed of the IMF, the ECB and the European Commission). At the same time, the fiscal discipline governing the budgets of EU countries has undergone major revisions through the update of the Stability and Growth Pact in late 2011 and the adoption of the treaty known as Fiscal Compact in March 2012. On the effectiveness of austerity policies, from the perspective of strengthening the European cohesion, many doubts have been cast. But this is an issue that should be discussed separately.
As of 2010, the ECB has fielded unconventional measures of monetary policy in order to contrast the credit crunch and meet its inflation target. Banks received massive liquidity injections in the form of extraordinary loans (LTROs and T-LTROs) and bonds purchasing programmes, such as the Securities Market Programme (SMP) and the European Quantitative Easing (QE).
In early 2015 the ECB launched QE on bonds issued by the public sector with the aim of countering the generalised deflationary environment and the credit crunch. However, QE has had little success in pursuing these targets: in the autumn of 2015, inflation expectations in the Eurozone were back to the levels before QE and, in early December, the ECB decided an extension of the programme to (at least) March 2017, compared the original expiry of September 2016. Several doubts arises over whether the programme will work, even in this enhanced version. A first critical point of QE is the almost complete lack of risk-sharing between the member countries (80 % of the overall purchases have to be carried on by the national central banks on the bonds issued by their respective governments)–once again, an indication that the Eurozone is a mere mosaic of states, rather than an authentic union. A further weakness of European QE is the inability to ensure that the liquidity injected will reach the real economy. The protracted crisis and the related drop in production and in the aggregate demand detonated non-performing loans (NPLs), making the disbursement of new loans difficult for banks without having to raise new capital in order to remain compliant with prudential regulations. At the same time, the predictability
