Eurozone Economic Crises and COVID-19: Policy Responses and Lessons

Posted on Aug 11, 2025 in Economy

The Three Crises of the Eurozone

Stage 1: The Global Financial Crisis

Following the Great Depression, strict regulation was designed to limit risk. The deregulation phase started in the 1980s, followed by a rapid expansion of financial sectors in the USA and Europe. Banks became active investors, leading to issues like:

  • Maturity mismatch
  • Currency mismatch

During the Great Moderation, banks took major risks, including providing house mortgages to high-risk individuals in the US. When house prices stopped rising, securities lost their ratings, and many of the world’s largest banks faced heavy losses. This led banks to grow suspicious of one another, halting mutual lending in the interbank market. Central banks responded by providing liquidity directly to their banks. Between September 2007 and spring of 2008, several major banks failed.

Policymakers (governments and central banks) applied lessons learned from the Great Depression:

  • Rescue large financial institutions.
  • Deep distress in the financial system is soon followed by a profound and long-lasting recession.
  • Central banks must provide liquidity to the financial system and adopt sharply expansionary policies.
  • Governments must bail out banks and other financial institutions.
  • Governments must use fiscal policy to prevent a vicious cycle of recession and large budget deficits.

Stage 2: The Public Debt Crisis

The recession was deep but relatively short-lived, though the Eurozone experienced a double-dip recession. Negative growth and large budget deficits rapidly increased public debts:

  • The financial crisis led governments to run budget deficits.
  • Deficits led financial markets to worry about the sustainability of public finances, triggering a second wave of the crisis.

Contagion within the Eurozone was highly troubling, as public indebtedness alone couldn’t explain why certain countries, and not others, faced the wrath of the financial markets. Possible additional explanations included:

  • No lender of last resort (e.g., the ECB did not buy government bonds of overly indebted countries, unlike the Fed or Bank of England; the Eurobonds idea was not accepted; the Euro was like a foreign currency to Eurozone members’ governments, largely due to fear of moral hazard).
  • Competitiveness issues.
  • Policy mistakes.

Competitiveness Challenges

Crisis countries were those that lost competitiveness due to high prices and wages. Current accounts deteriorated in less competitive countries (experiencing high inflation), while the opposite occurred in more competitive nations. Without their own currency, lost competitiveness could only be restored through wage and price moderation, which worried markets and led them to stop lending to these countries.

Policy Mistakes and Market Uncertainty

Initially, half-hearted and indecisive policy responses by the ECB and the European Commission led to high uncertainty in financial markets and significant pressure on governments. Step increases in interest spreads were attributed to policy decisions that markets perceived as ‘too little, too late.’

Policy Responses: Fiscal Measures

The fiscal policy strategy adopted was fiscal austerity, intended as a means to return to economic growth—a condition set by the Troika for bailout funds. However, austerity often worsened the recession, and fiscal policy in the Eurozone was much less expansionary. Key ‘Bailout Institutions’ were created:

  • The European Financial Stability Fund (EFSF) was established to provide financial resources in case of contagion, lending directly to problematic countries (Greece, Ireland, Portugal) without purchasing their debt.
  • The EFSF was replaced by the European Stability Mechanism (ESM) in 2012. The ESM is allowed to lend money for bank rescues under a lighter program called Precautionary Financial Assistance.

Policy Responses: Monetary Measures

The Eurosystem reduced interest rates to zero, but slower than the US and UK, drawing criticism for being too late. The ECB, however, maintained that its priority was price stability. Critics accused the Eurosystem of being ‘behind the curve,’ reacting slowly to events rather than being proactive. After Lehman Brothers, the ECB provided liquidity directly to banks, though its balance sheet expansion was less aggressive compared to the Fed and Bank of England, which doubled and tripled theirs.

In July 2012, then-President Mario Draghi announced that ‘the ECB is ready to do whatever it takes to preserve the euro.’ This commitment was formalized in September 2012 with the Outright Monetary Transactions (OMT) program, a drastic step that could be construed as financing deficits. The outcome reinforced the primacy of price stability as the Eurozone’s objective.

Banks and the Public Debt “Doom Loop”

Multiple equilibria emerged as the most serious threat of the crisis, leading to the concept of the ‘doom loop.’ Banks were ‘encouraged’ to buy public bonds as a means of upholding their value. As the crisis deepened, the share of national public debt in bank portfolios continuously increased. The doom loop thus locked governments and their banks in a dangerous embrace:

  • Banks depended on forgiving government supervision, but also on their countries’ public debt reputation.
  • Governments needed banks to support their bonds and were highly motivated to help them.

Lessons Learned from the Eurozone Crisis

Key lessons learned from the crisis include the importance of fiscal discipline, as very high debt creates serious difficulties:

  • It limits countercyclical fiscal policy.
  • It challenges monetary policy independence.
  • It possibly limits economic growth.

The crisis also highlighted the importance of enforcing the primacy of price stability as the central goal, recognizing that public support for the euro depends heavily on the economic situation.

COVID-19: Economic and Epidemiological Impact

How Pandemics Work: The Epidemiological Curve

The epidemiological curve is defined by the Reproduction number (R):

  • Reproduction number (R): How many other people does one infected person infect?
  • Exponential growth occurs if R > 1.
  • Herd immunity: As the number of immune survivors grows, R declines.
  • Exponential decay occurs if R < 1.

Flattening the Curve

Before herd immunity is achieved, many people may require hospitalization. Given the limitations in the capacity of hospitals to admit patients, interventions become crucial.

Interventions (Beyond Vaccination)

  • Reduce frequency of human contacts:
    • Lockdowns, restrictions on events, closing of schools, shops, etc.
  • Reduce the odds of contagion in case of contact:
    • Wear masks, wash hands, etc.
  • Zero-death vs. herd immunity strategy.

Macroeconomic Impact of COVID-19

The COVID-19 pandemic led to an extremely deep recession followed by an exceptionally fast recovery.

Economic Collapse Explained

The economic collapse was explained by:

  • Decreasing aggregate demand.
  • Decreasing mobility, consumption, and investment.
  • Decreasing aggregate supply.
  • Firms being forced to shut down or reduce activity.

Economic Recovery Explained

The economic recovery was explained by:

  • Increasing aggregate demand.
  • Restrictions being lifted, leading to spending of accumulated savings.
  • Increasing aggregate supply.
  • Firms rehiring and investing.