External imbalances and financial fragility in the euro area

This paper presents two views of the European sovereign debt crisis. The first is that the South in the euro zone has been fiscally irresponsible, and has failed to implement supply-side policies such as liberalizing labor markets and the market for services. The second view holds that the crisis reflects a deep divide between the external surpluses of the North and external deficits of the South. Basic stylized facts raise some doubt about the validity of the thesis that the debt crisis in the Eurozone is driven primarily by fiscal fragility in the South. A relatively simple model shows how poor fundamentals can create a debt problem independently of fiscal responsibility. The empirical analysis of the determinants of government bond yield spreads relative to Germany suggests that both views in fact provide useful insights into the roots of the current sovereign crisis. Fiscal fragility and external imbalances explain a significant share of the widening spreads since the onset of the global financial crisis. However, differences in labor productivity growth between North and South assume a much relevant role since the Greek crisis erupted in 2010.