Lessons from the European Economic and Financial Great Crisis: A Survey

Abstract

This paper discusses several key issues regarding the present European economic and financial Great Crisis, which essentially is a twin sovereign debt and banking crisis. The shift of the recent world financial crisis into a European sovereign debt crisis is tackled by analysing how via the banking system the financial contagion was extended from the US to Europe. The explanation focuses on the imbalances of European Monetary Union (EMU) countries balance-of-payments. The European crisis has shown that it can spread quickly among closely integrated economies, either through the trade channel or the financial channel, or both. In this context, TARGET2 payment system of EMU countries became crucial, reflecting funding stress in the banking systems of crisis-hit European countries. The paper concludes that, in the medium term, a successful crisis resolution requires more political integration, which will include a fiscal union and a banking union. However, in the short run, a prompt recovery is essential to get out from the troubles, and this requires that surplus countries (particularly Germany) expand aggregate demand and let domestic wages and the ensuing inflation rate increase.