Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone

Abstract

We provide a comprehensive account of the dynamics of eurozone countries from 2000 to 2012. We analyze private leverage, fiscal policy, labor costs, and spreads, and we propose a model and an identification strategy to separate the impact of credit cycles, excessive government spending, and sudden stops. We then ask how periphery countries would have fared with different policies. We find that countries could have stabilized their employment if they had followed more conservative fiscal policies during the boom. Macroprudential policies and an early intervention by the central bank to prevent market segmentation and reduce fiscal austerity would also have significantly reduced the recession. (JEL E24, E32, E58, E62, F33, F42, H61)