The current sovereign debt crisis is the direct result of credit expansion by the European banking system. In the early 2000′s, credit was expanded especially in the periphery of the European Monetary Union such as in Ireland, Greece, Portugal, and Spain. Interest rates were reduced substantially by credit expansion coupled with a fall both in inflationary expectations and risk premiums. The sharp fall in inflationary expectations was caused by the prestige of the newly created European Central Bank as a copy of the Bundesbank. Risk premiums were reduced artificially due to the expected support by stronger nations. The result was an artificial boom. Asset price bubbles such as a housing bubble in Spain developed. The newly created money was primarily injected in the countries of the periphery where it financed overconsumption and malinvestments, mainly in an overextended automobile and construction sector. At the same time, the credit expansion also helped to finance and expand unsustainable welfare states.
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The case of Spain is paradigmatic. The Spanish government subsidized the car industry, the construction sector, and the banking industry, which had been expanding heavily during the credit expansion of the boom. At the same time a very inflexible labor market caused official unemployment rates to rise to twenty percent. The resulting public deficit began to frighten markets and fellow EU member states, which finally pressured the government to announce some timid austerity measures in order to be able to keep borrowing.
.. The Eurosystem is unmasked as a self-destroying system that leads to massive redistribution across the EMU, with incentives for governments to use the ECB as a device to finance their deficits. He shows that the concept of the Tragedy of the Commons, which I have applied to the case of fractional reserve banking, is also applicable to the Eurosystem, where different European governments can exploit the value of the single currency.
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