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The comparative political economy of the sovereign debt crisis in Italy and Spain

Lucia Quaglia (University of York)[footnoteRef:1] [1: Lucia Quaglia wishes to acknowledged financial support from the European Research Council (204398 FINGOVEU) and the British Academy (SG 120191). This paper was written while she was visiting fellow at the Max Planck Institute, the European University Institute and Hanse Wissenschaftskolleg. All errors and omissions are ours.]

Sebastin Royo (Suffolk University)


This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis and had to resort to euroarea financial assistance, whereas Italy did not. It dissects the sovereign debt crisis into a banking crisis and a balance of payment crisis, arguing that banks business model and distinctive features of national banking systems in Italy and Spain have considerable analytical leverage in explaining the different playing out of the crisis in the two countries. External factors, first and foremost, the idiosyncratic behavior of financial markets and the delayed response of the EU, worsened the crisis. Bond markets spread contagion effects, which irresolute EU intervention did not prevent.

1. Introduction

The sovereign debt crisis in Europe dealt a major blow to the international economy. The periphery of Europe was particularly badly hit by this crisis: Greece was the first victim, followed by Ireland, Portugal, Spain and Italy. Despite the fact that all these countries often collectively referred to with the unflattering acronym of PIIGS (Portugal, Italy, Ireland, Greece and Spain) - were hit by the sovereign debt crisis, there are important differences concerning the causes, the dynamics and the outcome of the crisis across countries.

This paper sets out to explain why Spain experienced a fully-fledged sovereign debt crisis and had to resort to Euro-area financial assistance, whereas Italy did not. This is puzzling for three reasons, which explain why these countries have been chosen for a structure focused comparison. First, at the onset of the banking crisis in the 2007, Spain had a surplus in its budget and its public debt was much lower than in Italy, whose public debt exceeded 100% of GDP. Hence, Italy seemed to be a more likely candidate for a sovereign debt crisis than Spain, which was on sound fiscal footing (see Table 1).

Second, in the academic literature, Italy and Spain are often lumped together in the same variety of Southern European capitalism, which admittedly, is a residual category for countries that cannot fit into liberal market economy and coordinated market economy models. Consequently, one could have expected similar causes and outcomes of the crisis in the two countries. Finally, in much of the popular press and policy-makers discourse (especially in so-called creditor countries, such as Germany) the sovereign debt crisis is often ascribed to the inability of fiscally lax Southern European countries to adjust to Economic and Monetary Union (EMU) and to sort out their fiscal imbalances in the boom years. Yet, as this paper shows, this was the case in Italy but not in Spain, where the main cause of the crisis laid in a specific part of the banking sector.

Methodologically, the paper engages in a structured focused comparison of the playing out of the sovereign debt crisis in Italy and Spain. It dissects the sovereign debt crisis into a banking crisis and balance of payment crisis. Spain experienced a banking crisis: the bailing out of banks substantially increased the public deficit and debt. By contrast, Italian banks, with one exception, did not experience significant losses. Spain also experienced an unconventional balance of payment crisis: when capital flew out of the country, euro-area assistance was called upon to rescue ailing banks. Spain had a much higher net foreign debt than Italy: a large part of that debt was private and generated by Spanish banks. Italy suffered from chronic fiscal imbalances: it had lived with a high level of public debt (mostly domestically held) for decades, but posted primary surpluses. However, the low growth rate in Italy challenged the sustainability of the debt.

The paper investigates the domestic causes of the crisis, without ruling out the role of external factors, first and foremost, the idiosyncratic behavior of financial markets and the delayed response of the EU in worsening it. It is argued that banks business models and distinctive features of national banking systems in Italy and Spain have considerable analytical leverage in explaining the different playing out of the sovereign crisis in these two countries.

By focusing on banks role in the playing out of the crisis, the paper contributes to three distinct but interconnected bodies of literature in political economy. First, the research pioneered by Hardie and Howarth (2013; see also Hardie et al. 2013; Deeg 2013) that focuses on banks activities in order to explain the evolution of national financial systems. Second, the literature on domestic political economy institutions and economic policies, in particular the role of these institutions in mediating the effects of external (macro-level) factors. Third, it contributes to the literature on sovereign debt crisis, which so far has mostly focused on developing countries. It questions the explanatory power of the literature on varieties of capitalism with reference to the sovereign debt crisis.

The paper is organised as follows. Section 2 briefly reviews the literature on the macro and meso level explanations of the crisis. Sections 3 and 4 examine the anatomy of the banking crisis and the balance of payment crisis in Italy and Spain, pointing out the role played by banks in fuelling these crises in Spain but not Italy. Section 5 discusses the impact of external factors, in particular bonds markets; and euroarea interventions in the unfolding of the crisis.


Table 1: Main Economic Indicators 2007-2013

CountrySubject DescriptorUnits2007200820092010201120122013

ItalyGDP% change1.683-1.156-5.4941.8040.431-2.292-0.73

ItalyInflation% change2.0383.50.7641.6392.9023.0141.813

ItalyUnemployment rate% labor force6.1086.7837.8088.4088.42510.55211.064

ItalyGovernment structural balance% potential GDP-3.292-3.476-3.635-3.282-3.406-0.6370.586

ItalyGovernment net debt% GDP86.89288.78197.19499.09899.62103.073103.908

ItalyCurrent account balance% GDP-1.242-2.905-2.061-3.551-3.26-1.476-1.36

SpainGDP, constant prices% change3.4790.893-3.742-0.3220.417-1.538-1.316

SpainInflation% change2.8444.13-0.2382.0433.0522.442.426

SpainUnemployment rate% labor force8.27511.31820.07521.6524.925.1

SpainGovernment structural balance% potential GDP-1.13-5.019-9.021-7.317-7.482-5.389-3.518

SpainGovernment net debt% GDP26.730.80142.49149.80557.48578.62684.43

SpainCurrent account balance% GDP-9.995-9.623-4.822-4.521-3.526-1.973-0.148

International Monetary Fund, World Economic Outlook Database, October 2012

2. State of the art and research design

A sovereign debt crisis occurs when a government defaults on its debt (Reinhart and Rogoff 2009) or is unable to borrow funds on the markets and has to resort to external financial aid (Hardie 20121), such as the International Monetary Fund (IMF). A banking crisis occurs when a country's financial and banking industry experiences a significant number of defaults andas a consequence a large part of the capital in the banking system is reduced.[footnoteRef:2] A balance of payment crisis is preceded by persistently high current account deficits and net capital inflows into a country, followed by massive and sudden outflows of capital from the country, which triggers the crisis. [2: http://www.stlouisfed.org/publications/re/articles/?id=2096 accessed in January 2013]

The literature in economics has paid considerable attention to the economic factors associated to sovereign debt crises. One of the most extensive studies of financial crises over two centuries highlighted a strong causal link between banking crises and sovereign defaults in developed and developing countries (Reinhart and Rogoff 2009). In their book, Reinhart and Rogoff reached three conclusions: i) private debt surges fuelled by domestic banking credit growth are recurring antecedents to banking crises, ii) banking crises often precede or accompany sovereign debt crises; iii) governments often have hidden debts. Another paper pointed out the link between banking crises and balance of payment crises (the so called twin crises) (Kaminsky and Rogoff 1999). Kaminsky and Rogoff found that problems in the banking sector typically precede a currency crisis - the currency crisis deepens the banking crisis, activating a vicious spiral; financial liberalization often precedes banking crises. Crises occur as the economy enters a recession, following a prolonged boom in economic activity that was fueled by credit, capital inflows, and accompanied by an overvalued currency. These accounts, written by economists, are somewhat de-voided of politics and one is left to explain the causes of banking crises and the balance of payment crises in the first place.

In the political economy literature, several complementary explanations have been put forward for the occurrence of sovereign debt crises, mainly in developing countries. These explanations can be articulated at the macro-level (international level), meso-level (ie national level) and micro-level (Germain 2012). At the macro-level, different authors have pointed out a variety of factors that can fuel sovereign debt crises, namely: the impact capital liberalization (XXX); the activity of bond markets (Mosley 2003) and financial innovation, especially financialisation (Hardie 2011); the spread of neo liberal ideas (Major 2012 ); and the lack of a proper hegemon in the international system (cf Kindleberger 1973), or more recently in the European Union (Mabbet and Schelke 2013).

While some elements of the crisis can certainly be explained by international systemic factors, particularly the withdrawal of foreign funds, macro-level factors are basically the same for all countries, especially within the relatively homogenous regional block of the euroarea. Hence, they are not very well suited to explain differences in the playing out and outcome of the sovereign debt crisis across the euroarea. They are background factors that have fuelled the sovereign debt crisis, but national level factors are better suited to explain different dynamics and outcomes of the crisis across countries (see Jabko 2012; Haggard and Mo 2000).

An obvious starting point in order to investigate the importance of national level factors in the playing out of the sovereign debt crisis is the literature on varieties of capitalism (for some comprehensive analyses, see Amable 2003, Hancke, Rhodes, and Thatcher 2007; Hall and Soskice 2001; Schmidt 2002; for a review, see Jackson and Deeg 2010). This body of work has examined the main components of varieties of capitalism, namely: industrial relations institutions; education and training systems; corporate governance and systems of corporate financing; product markets; social protection systems and welfare states; and public intervention in the economy. The financial system has also been considered as one of the components of the variety of capitalism, but the attention has mostly been on the sources of corporate finance (see Zysman 1983, see also Deeg 2010).

This literature has generally focused on the Anglo-Saxon and continental varieties of capitalism, characterizing them, respectively as liberal market economies and coordinated market economies. The Southern European countries have mostly been overlooked or placed in a residual category of Southern European or State- led model of capitalism (Schmidt 2002; Della Sala 2004).[footnoteRef:3] The literature on varieties of capitalism is of limited utility in order to explain the dynamics and outcome of the sovereign debt crisis in Italy and Spain, as it would predict similar (not different) outcomes. To be fair this literature was not developed with a view to explaining sovereign debt crises, but rather to tease out institutional complementarities that can enhance or hinder the competitiveness of national economic systems in the world economy. [3: Indeed, this literature has been criticized for overlooking of countries that do not fit easily into liberal market economies and coordinated market economies, for neglecting the role of the state and the broader macroeconomic framework. An exception is the work of V. Schmidt (2002) that has brought the state and its macroeconomic institutions back in into the analysis of varieties of capitalism.]

Two other bodies of literature are useful to investigate domestic factors at the origins of the crisis. The first is the research pioneered by Hardie and Howarth (2013; see also Hardie et al. 2013; Deeg 2013) that focuses on banks activities in order to explain the evolution of national financial systems. Since banks were at the epicenter of the crisis, it is important to understand what they were doing in the run up to and during the crisis. Furthermore, the literature on domestic political economy institutions and economic policies draws our attention to the role of domestic factors in mediating the effects of external (macro-level) factors, for example framing the impact of liberalization (Deeg and Perez 2000), and/or bringing about domestic economic reforms (Perez 1997, Perez and Westrup 2008).

The dependent variable of this research is the playing out of the sovereign debt crisis in Italy and Spain. In June 2012, the Spanish government requested euroarea financial assistance, which was agreed by the Eurogroup meeting in July. It was agreed that financial assistance from the euroarea member states was to be provided to the bank recapitalisation fund of the Spanish government, and then channeled to ailing financial institutions in Spain. In December 2012, the Spanish government formally requested the disbursement of about 39.5 billion of funds.[footnoteRef:4] By contrast, the Italian government has not requested outside financial assistance to date, even though, like Spain, it benefited substantially from the purchase by the European Central Bank of government bonds in the secondary markets in an attempt to reduce borrowing costs, as discussed below. [4: http://ec.europa.eu/economy_finance/assistance_eu_ms/spain/index_en.htm accessed in March 2013.]

This different outcome of the crisis is explained by the fact that Spain experienced a banking crisis and balance of payment crisis, whereas Italy did not. In Spain (but not in Italy), there was also a real estate bubble: the banking crisis cannot be understood without reference to the real estate bubble. In parallel to the banking crisis, Spain experienced a balance of payment crisis. Spain had a high net foreign debt, fuelled in the bonanza years by capital inflows. When the banking crisis gained momentum in Spain and capital flew of the country, external (euroarea) assistance was called upon. Italy escaped the worst of the sovereign debt crisis mainly because of its relatively low external debt and balance of payments imbalances as compared to Spain. Italy had lived with a high public debt for decade, but the level of private debt was rather low, and the public debt was mostly domestically owned. For example, Japans public debt exceeds 200% of its GDP, but is mostly domestically held and the country has not been threatened by a sovereign debt crisis.

What explain the banking crisis and the balance of payment crisis that conflated into the sovereign debt crisis and the request for external financial assistance in Spain but not in Italy? This paper argues that a key role was played by banks. In other words, banks business model and the distinctive features of the banking sector in Spain and Italy account for the banking crisis and the property bubble in Spain and for the absence of a banking crisis and a property bubble in Italy. Banks also contributed to fostering the external imbalances that caused a balance of payment crisis in Spain, whereas this was less the case for Italian banks.

3. The (late) banking crisis in Spain but not Italy

Initially, after the collapse of the the subprime market in the US in late 2007 and the bankruptcy of the US financial firm Lehman brothers in October 2008, Italian and Spain banks weathered the banking crisis rather well: they did not experience major losses and did not need state recapitalisation. The limited impact of the banking crisis in Italy and Spain is explained by the banks business model and balance sheets, which were in turn influenced by the sound regulatory framework in Italy and Spain (see Barth and Levine 2006).[footnoteRef:5] Moreover, Italian and Spanish banks were relatively sheltered from the most intense forces of global financial contagion in 2008-9: Italian and Spanish banks did not invest in fancy financial products that later proved to be toxic. The expansion abroad of Italian and Spanish banks was mostly in retail business, with ownership of retail subsidiaries and participation in banking groups in Central and Eastern Europe, for Italian banks, and Latin America for Spanish banks. [5: The data produced by Barth and Levine (2006) on capital stringency and bank regulation show the diversity of regulatory practice across countries. Italy and Spain scored high in terms of stringency of regulation.]

Nonetheless, in late 2009, major financial problems began for the Spanish saving banks (cajas), which had to be recapitalised first by the Spanish government and then through euroarea financial assistance. Italian banks, with the exception of the recent case of the Monte dei Paschi, did not experience significant losses. The bad performance of Spanish cajas is explained by bad mortgages and loans to construction companies, which in turn fuelled a property bubble in Spain. The Bank of Spain had limited supervisory competences on the cajas, whose management was affected by the interference of local politicians. Italian banks, less subject to political interference, mainly lent to non financial corporations, especially small and medium enterprises.


At the outset of the global financial crisis, in Italy (as in Spain) the majority of banks assets were loans to customers, and a significant part of banks assets involved national government securities, which at that time were considered among the safest possible asset investments (Pagoulatos and Quaglia 2013, Royo 2013b). Unlike Spanish banks, Italian banks did not fuel a property bubble: they lent to households far less than either Spanish or Greek banks. Lending to Non-Financial Corporations (NFCs) was higher in Spain, than in Italy and Greece, though not really dramatic. However, in Spain the NFC lending included a very large proportion of property developers, especially for the cajas, as explained below. Data from the Bank of Italy (2008c) suggest that Italian banks were predominantly lending to NFCs, and that amongst NFCs, the bulk of the loans went to services and industry, not building (see Table 2). Obviously, a property bubble can come also from residential mortgage lending, but there was no significant rise in consumer lending in the years preceding the crisis.

On the liabilities, Italian and Spanish banks had a broad and stable funding base. Funding from retail customers, more stable than wholesale funding, constituted a large share of the total liabilities in both countries (Pagoulatos and Quaglia 2013, Royo 2013b). However, banks in both countries also depended on wholesale inter-bank funding, which some importance differences. First, Italian banks tended to lend mostly to each other. The average home bias for Italy was the highest in the euro areas national banking systems (Manna 2011). At the height of the crisis, banks cut their lending to banks in other countries far more than their lending to banks in their own country, so the fact that Italian banks lent to each other suggests that inter-bank borrowing was more stable than in those systems (like Spain) where inter-bank funding was largely from abroad.

Second, although Italian banks have high levels of wholesale funding, this is relatively longer term: ninety-three per cent of debt securities issued by Italian banks are over two years in maturity and none are under one year. For Spanish banks, the figures are seventy-three and twenty-two per cent respectively. Third, several of the debt securities issued by Italian banks were sold to their customers, which made this sort of funding less subject to the vagaries of the financial markets. Italian banks have greater access to retail investors for their bond issues than elsewhere in Europe (Bank of Italy 2011).

Table 2. Italian banks loans distribution by: Customer segment of economic activity

September 2007October 2008TOTAL LOANS (million of euros) 1,453,323 1,500,679 SEGMENT OF ECONOMIC ACTIVITYGeneral government 56,985 58,357 Financial companies 161,470 168,448 Non-financial companies 775,447 809,079 of which: Industry 259,068 274,649 Building108,621 110,943 Services393,365 408,285 Producer households 88,665 89,645 Consumer households 370,809 375,151 Bank of Italy (2008). Summary Report of the Statistical Bulletin 2007-2008, Data on credit, securities business and interest rates, quarter 4, p.3.

The only Italian bank that experienced serious problems as a consequence of the global financial crisis was the Monte dei Paschi di Siena, which is the worlds oldest bank. In February 2013, it was the subject of a major scandal involving losses of 730 millions euros from (toxic) financial products that had previously been hidden from the supervision of the Bank of Italy. The transactions took place between 2007 and 2009. The scandal discredited the bank's former management, which was by and large appointed by local politicians (the municipality of Siena and the region of Tuscany are mostly governed by the Democratic party). It exposed the close lies between politicians and banks. It also questioned the supervisory activity of the Italian central bank, the Bank of Italy, which has extensive supervisory powers. The supervisory department of the Bank of Italy pointed out that the management of the Monte dei Paschi had hidden from the central bank the toxic transactions that led to financial losses.

Unlike in Spain, in Italy there was not direct competition between commercial banks and savings banks, which were subject to the same regulatory framework. The banking reform in Italy in the late 1990s and early 2000s was instrumental in facilitating the merger of commercial banks and saving banks, as well as in modernizing the Italian banking system. Prior to the reform, saving banks in Italy, like the cajas, tended to have close ties with local communities and local politicians (Deeg 2013), as it was still the case for the Monte dei Paschi.

Despite the Monte dei Paschi debacle, banking supervision in Italy has been assessed as systematic and diligent during the crisis and in the years preceding it (IMF 2008). The Bank of Italy, like the Bank of Spain, discouraged lenders from adopting risky off balance sheet accounting methods and from acquiring billions of Euros of repackaged US subprime mortgages and other toxic assets. Moreover, the Bank of Spain and Bank of Italy were instrumental in forcing banks to focus on conservative risk management and quality of capital, limiting their leverage and the debt to equity ratio.


In Spain, between 2008 and 2010 the financial system was still one of the least affected by the crisis in Europe. In December 2010 Moodys ranked the Spanish banking system as the third strongest of the Eurozone, only behind Finland and France. Spanish banks, like Italian banks, had a rather traditional business model. As in the case of Italy, in Spain the majority of banks assets were loans to customers. On the liabilities, Italian and Spanish banks had a broad and stable funding base, mainly from retail customers (Pagoulatos and Quaglia 2013, Royo 2013b). However, Spanish banks raised funding on the wholesale market more than Italian banks, which made the former more vulnerable to the credit crunch (it the freezing of the interbank market) than the latter. The Bank of Spain had imposed a regulatory framework that required higher provisioning, which provided cushions to Spanish banks to initially absorb the losses caused by the outset of the global financial crisis (Royo 2013a).

Nevertheless, the relative success of the Spanish banks proved short lived. The collapse of the real estate market eventually led to a traditional banking crisis fueled by turbo-charged lending funded on the interbank-market on the liability side of the Spanish banks balance sheets. However, Spain was rather unique in the fact that the largest banks did not face large problems. While the cajas were struggling under the weight of bad mortgages and loans to construction companies, the exposure of Big Threes large private banks to toxic assets associated with the Spanish real estate sector was a relatively small problem. BBVA and Santander diversified internationally gaining access to funding and capital that allowed them to liquidate the toxic property assets at a lower price than their rivals, and with limited damage to their earnings.

When looking at the performance of the Spanish financial system, it is very important to distinguish between the large banks and the cajas - unlisted in the stock market, regionally based, and often politicized savings banks accounting for half of the financial sectors assets. The large banks performed relatively well during the crisis while the cajas suffered from a somewhat traditional financial crisis. Much of what the cajas were doing was lending to NFCs in construction, rather than just mortgage lending. Yet, a key element that separates this crisis from a traditional one, particularly on the cajas side, is their heavy borrowing on the interbank market (Carballo Cruz 2011). This distinction is unique in comparative terms; in no other country were small banks uniquely hit and large banks left largely unscathed.

During the boom years, the cajas successfully captured market shares from the banks, investing heavily in real estate (lending both to consumers and companies). Significant levels of interbank liabilities were taken on by both the big Spanish banks and the cajas, but in particular by the cajas in the context of their efforts to expand and strengthen their national presence, as illustrated most visibly by a rapid growth in the number of employees and branches. When the economic recession kicked in, they were exposed to the collapse of that sector and the payment difficulties of mortgage holders. Cajas, highly dependent on international wholesale financing, were also forced to turn to the government and the ECB for liquidity when wholesale markets froze.[footnoteRef:6] Fortunately for the largest Spanish banks, their geographical diversification helped them to counterbalance their domestic losses. [6: By May 2010, 34 of the 45 cajas were involved in merger and restructuring discussions; it was expected that that would lead to the creation of 11 new cajas.]

In the end in Spain the financial system, to be precise the cajas was unable to decouple itself from the economic cycle and the huge macroeconomic crisis that has besieged the country. The deteriorating economic conditions had a severe impact on the banks balance sheets. The liquidity problems of Spanish banks problems were reflected in their dependence on the ECB. Spanish banks increased their ECB borrowings by more than six times since June 2011. In March 2012, they borrowed a record 316bn euro from the ECB, 28 percent of the euroarea total, the highest level in absolute terms among euro area banking systems (Royo 2013b).

In Spain, the distinction between banks and cajas is key to understand the banking crisis that developed from 2010 onward. Indeed, their performance has been very different. A crucial reason for this divergence was the difference in their regulatory framework. Cajas are very peculiar credit institutions because they used to dedicate a significant portion of their provisions (usually over 20 percent) to social causes, and, prior to the crisis, they have strong links with the regions in which they operate. They are regulated by both the national government (in charge of basic norms) and by the autonomous communities governments (in charge of application and development of the rules established by the central government). Political institutions (parties and unions) participate in their governing bodies.[footnoteRef:7] This proved to be a gaping hole in the regulatory framework, and had devastating consequences. [7: However, it is important to stress that political control was not always detrimental. In the Basque Country, there was strong political control of the cajas, and still the Kutxa channeled most credit towards the business sector (Fisham 2012).]

Since the crisis started, the country adopted five financial reforms in three years, and implemented three rounds of bank mergers (for more details, see Royo 2013c). Many cajas were merged and their number dropped from 45 to 9. The Spanish government repeatedly increased the capital provisions. Those banks unable to meet the new provisioning rules were able to borrow the additional money in the form of state-backed convertible bonds carrying a 10% interest rate. Furthermore, banks could transfer their riskiest assets to state-guaranteed asset management companies to help speed the sale of real estate assets the bank holds. Each bank was forced to create a bad bank into which it will put physical property assets at marked down valuations, in preparation for potential sales to outside investors.

In May 2012, the Spanish government was forced to nationalize Bankia the countrys largest real estate lender and the result of the merge of several ailing cajas. This was the largest bank nationalization in the countrys history and was overseen by the Bank of Spain. The failure of Bankia validated some concerns about insufficient regulatory oversight and the perception that banks and the Bank of Spain had played down the risk posed by real estate loans. In August 2012, a new financial reform was approved in response to the EU financial rescue package. It created a bad bank that could absorb the toxic assets from the real estate sector, and had the authority to buy and sell all kind of assets and to issue bonds. The reform reinforced the role of the Bank of Spain in the creation of the bad bank. It also established a new process to restructure and liquidate financial institutions and it gave a central role in that process to the FROB and the Bank of Spain. Finally, the reform reduced the role of the regional governments in the restructuring and liquidation of cajas and saving cooperatives. These five reforms in less than three years were largely perceived as too little and too late, and failed to sway investors confidence in the Spanish financial sector. Both the Socialists and Conservative governments were reluctant to admit the depth of the liquidity and solvency problems of many institutions, particularly the cajas, where politics has continued to play a role throughout the crisis.

4. The balance of payment crisis in Spain, but not Italy

Both Italy and Spain suffered from internal and external imbalances. As Bini Smaghi put it (2008) external imbalances are the reflection of internal imbalances. All the periphery countries hit by the sovereign debt crisis had a persistent current account deficit over the last decade or so, coupled by significant private capital inflows from 2002 to 2007-9. In comparison to the other countries, in particular to Spain, which had the largest current account deficit in the euroarea, Italy had a much smaller current account deficit. It also experienced very limited capital inflows.

In the first four countries, large current account imbalances were mainly funded through portfolio debt securities and banks loans (Commission 2006), not so much by foreign direct investment, with the exception of Ireland. As Merler and Pisani-Ferry (2012) note Such a financing structure, biased towards banks intermedia-tion, rendered the deficit countries very exposed to the unwinding of capital inflows... Indeed, when the banking crisis began, followed by the sovereign debt crisis, the capital inflows of the previous decade were followed by large capital outflows.

This trend was reflected by the positions of the eurosystem central banks in the TARGET 2 the interbank payment system of the Eurosystem. Until 2007, TARGET 2 positions were close to balance. When the global financial crisis began in 2007 and even more so when the sovereign debt crisis broke out in 2010, imbalances emerged within TARGET 2, whereby Germany was the largest creditor and Greece, Spain, Ireland and Portugal were net creditors. Italy became a major net debtor in TARGET 2 in the summer of 2011. As Merler and Pisani-Ferry explain Once the crisis broke out in the euroarea, sub-stitution of private-capital inflows by public inflows, especially Eurosystem financing, helped accommodate persistent current-account deficits [footnoteRef:8] [8: Merler and Pisani-Ferry (2012) estimated that the cumulated net position of the northern euro-area central banks reached 800 billion in December2011, being matched by the southern euro-area central banks' equivalent negative position.]


Despite the tendency to lump Spain, Italy, Greece, Portugal and Ireland together and view the crisis as caused by fiscally irresponsible governments, Spains public finances were in robust shape prior to the European sovereign debt crisis: public debt was only 36.3% of GDP, and the country had budget surpluses from 2003 through 2007. In Spain, the public deficits and then the debt soared as a consequence of the crisis, in response to which the government implemented an 8 billion public-works stimulus. These expenses, combined with the fall in revenues, the need to recapitalize a large number of Spanish banks (see previous section) and the deficits run by the regions, blew an enormous hole in the public accounts (see Table 1).

The regions struggled to cut their budget deficits, were shut out of the credit markets, and were crippled by mountains of debt accumulated during the boom years. Many of these regions asked the national government for emergency financing, tapping into the 18bn fund set up by the central government to help regional governments meet their debt repayment obligations. The regional governments combined debts of 140bn euros, of which 35bn euros matured in 2012. Hence, Spains regional state structure, and with the exception of the Basque Country and Navarra, the very limited fiscal powers of the regional governments worsened the state of public finance.

The key problem for Spain, unlike Italy, was not so much the public sector debt in as much as the private-sector debt, driven by record-low interest rates after the country joined EMU and fuelled by reckless banks investments and loans (see Table 3). These, in turn, fuelled a property bubble, which Italy, unlike Spain, did not experience. Land prices increased 500 percent in Spain between 1997 and 2007. At the end of 2010, the International Monetary Fund (IMF) reported that Spain had the largest real estate bubble in the developed world. But the global financial crisis burst it: because of high unemployment and lower wages caused by the economic crisis many mortgage holders were unable to repay their debt.

By the end of 2011, land prices, adjusted for inflation, had fallen about 30 percent from the 2007 peak, and home prices were off about 22 percent. House prices fell by 11.2 percent in 2011 alone, while in Madrid, prices went down by 29.5 percent. Expectations, however, are that the entire original house price increases may be reversed, so prices would have to fall 40% from that level.[footnoteRef:9] The implosion of the real estate market exposed the vulnerability of the banking sector to that market, which constituted 60 percent of the banking loans (i.e., loans to families, enterprises in the real estate sector or direct real estate assets), as explained in the previous section, which pointed out the role of banks and municipalities in fostering the bubble. In Spain, the decision by the cajas to channel funding disproportionally to the construction sector (both to construction companies and real estate developers) and toward private mortgages (their reticence to lend to SMEs outside of the construction and real estate sectors) was critical to fuel the bubble in that sector (see Serra Ramoneda 2011). Moreover, restrictive lending to SMEs was one of the reasons that accounts for the poor labor market performance of the country because it undercut these firms efforts to create jobs and innovate (Fishman 2010, 293299). [9: A complacent Europe must realize that Spain will be next, in Financial Times, April 11, 2011. ]

Unlike in Italy, the main fiscal problem in Spain was not the total amount of its public debt, but rather the fact that it is mostly held abroad. Hence, the countrys problems intensified when foreign investors became more reluctant to refinance its debt, as reflected from the increasing yields in the last two years (see Figure 1). This high degree of Spains external indebtedness was partly the consequence of the record current account deficits that Spain suffered during the first decade of EMU membership. Since joining the final stage of EMU the current account has been in deficit in Spain. In 2007, it reached the record of almost 10% of GDP, one of the highest in the euro area. These current account imbalances were funded through portfolio debt securities and banks loans (Commission 2006). As Merler and Pisani-Ferry (2012) note banks intermediation played a key role in attracting capital inflows and channeling them in the construction sector, rendering the Spanish economy vulnerable to the sudden withdrawal of these funds.

Figure 1. Debt Burden in Selected Advanced Economies (Percent of GDP)

Source IMF Global Financial Stability Assessment 2012.


In Italy the gross public debt was very high before the crisis. Italy has managed a public debt above 100 GDP for the last three decades. On the negative side, the Italian government failed to take advantage of the low interest rates following the entry of the country into EMU in order to substantially reduce the outstanding public debt (refs needed). On the positive side, Italy has run a primary surplus from 1992 onwards, with the exception of a primary deficit in 2009 and 2010, which were mainly due to a falling growth rate (see Table 1).

The main problem in the Italian case was not so much the high level of public debt, especially taking into account that the relatively low level of private debt and the fact that the public debt is mostly held abroad. Italy had lived with a high public debt for decades. However, the very low growth rate raised serious issues about the sustainability of the public debt (Jones 2011). Italy has been suffering from low economic growth for more than a decade: 0.54 per cent annual average real GDP growth between 2000 and 2010 versus 1.37 per cent for the euroarea, whereas economic performance in Spain was significantly better during the decade prior to the crisis (thanks largely to the state bubble). Since the beginning of the crisis, the low or negative economic growth and rising unemployment in Italy and Spain worsened the state of the public finance.

Table 3. Indebtedness and Leverage in Selected Advanced Economies

(Percent of WEO projections for 2012)

Euro AreaItalySpain

General Government Debt



Primary balance-0.53-3.6

Household Debt



Nonfinancial Corporate Debt


Debt divided by equity (percent)106139149

Financial Institution

Gross debt14297109

Leverage of domestic banks231920

Bank claims on public sectorn.a.3226

External Liabilities



Government debt held abroad254928

Source. IMF Global Financial Stability Assessment 2012

Unlike Spain, Italy had a limited degree of external indebtedness and did not experience the high level of capital inflows that Spain had. This was the consequence of the relatively small current account deficits that Italy suffered during the first decade of EMU membership and the high saving rate in the country. Far more export-led than all other Southerners, Italy had a lower current account deficit (see Table 1). Unlike Spain, Italy has the second-largest manufacturing and industrial base in Europe, after Germany, and is one of the biggest export-oriented economies in the euro zone. Made in Italy is still a valuable brand the over the world. Moreover, Italian banks did not perform the intermediating function that Spanish banks had by channeling capital inflows into a property bubble.

Both Spain and Italy suffered from a loss of competitiveness since joining EMU, hence once they gave up the possibility of devaluing their currency. Between the introduction of the euro and 2008, unit labor costs in the manufacturing sector, the strongest indicator of the economys competitiveness, increased substantially in Italy and Spain (see Figure 2). During that period, the countries productivity increased marginally. According to the World Economic Forums annual 2012 competitiveness ranking one of the shared features of the current situation in all these [Southern European] economies is their persistent lack of competitiveness.Over all, low levels of productivity and competitiveness do not warrant the salaries that workers in Southern Europe enjoy and have led to unsustainable imbalances, follow by high and rising unemployment.

Figure 2

Source: OECD.

5. Macro level factors: Bond markets and euroarea assistance

There are two types of external factors that are important in the playing out of the sovereign debt crisis in Italy and Spain: the reactions of the bond markets as manifested by the spread between Italian and Spanish bonds yields and German ones, and external financial assistance. In Spain, there was no IMF financial assistance. euroarea financial assistance has taken three forms in Spain: provision by the Eurosystem of liquidity to the banking sector through TARGET 2 (see Section 3); ECB purchases of sovereign bonds under the SMP and euroarea assistance programmes. Both in the case of Italy and Spain these external factors were mostly a function of the domestic development in the two countries, rather than being causes of the sovereign debt crisis. Bond markets contributed to the contagion effect that hit Spain and especially Italy. Delayed and ad hoc euroarea financial assistance also contributed to this.

When the sovereign debt crisis broke out in Greece in 2009-2010, Italy and Spain were initially unaffected, as suggested by the ten years spreads on government bonds for Italy and Spain versus the German bunds (see Table 4). Spain began to face serious problem in the bond market in the second half of 2010 because of rising concerns about the crisis in the financial sector, the continuing decline of the real estate sector, and the impact of the economic recession. The Socialist led government overestimated the capitalization of Spanish companies, the resilience of the Spanish financial system, the strength of the counter cyclical dynamic provision system; and the openness and competitiveness of the Spanish economy. At the same time, the attempt to force restructuring through mergers backfired, as proven by the Bankia fiasco (a savings and loan that had to be nationalized in the Spring of 2012): the governments failed to recognize that merging weak banks does not create a strong one.

Italy began to face serious problem in the bond market in the summer of 2011: the spread between Italian ten-year bonds and their German counterparts widened; Italian sovereign debt yields moved above those charged to Spain; and rating agencies downgraded the creditworthiness of the Italian government and consequently of Italian banks. [Beside the economic crisis, Italy was also facing a political crisis, with several scandals (including sex with an underage woman) involving the then Prime Minister Silvio Berlusconi. There was also an open conflict within the government between the Prime Minister and the Treasury Minister Giulio Tremonti, which weakened the government coalition. The deterioration of the fiscal situation and the inability of the centre-right government of Silvio Berlusconi to put together a convincing adjustment package, together with strong diplomatic pressure from abroad, led to the government resignation and the nomination of the technocratic government headed by Mario Monti in November 2011 (Jones 2011).

Spain also underwent a change of government, though not to a technocratic one. The Partido Popular government, which came to power at the end of 2011, sought to convince the market of the governments commitment to austerity and structural reforms, but without positive results. They tried to execute a hail Mary in the form of deep cuts and structural reforms, but this shock and awe strategy did not work. If anything, the PP government policies in the first half of 2012 were also mired in parochialism, often showing more concern about political interests than doing the right thing.

Table 5: Ten Years Government Spreads for Italy and Spain (2009-2012)

Bonds-Ten Years Government Spreads (September 30th, 2009)

Bid YieldSpread Vs. Bund



Bonds-Ten Years Government Spreads (September 30th, 2010)

Bid YieldSpread Vs. Bund



Bonds-Ten Years Government Spreads (September 30th, 2011)

Bid YieldSpread Vs. Bund



Bonds-Ten Years Government Spreads (September 28th, 2012)

Bid YieldSpread Vs. Bund



Bonds-Ten Years Government Spreads (November 23rd, 2012)

Bid YieldSpread Vs. Bund



Source: Thomson-Reuters

In December 2011, the ECB launched a program of Long Term Refinancing Operations (LTRO), issuing loans at the interest rate one per cent for a period of three years to European banks, accepting government bonds, mortgage securities and other commercial papers in the portfolio of the banks as collaterals. At the same time, the ECB changed its rules on collaterals, accepting lower quality collaterals in return for its loans. Under this program, the ECB loaned 489 billion to 523 banks, mainly in Greece, Ireland, Italy and Spain. Indeed, Italian and Spanish banks took about sixty per cent of all the net new loans from the ECB, with Spain's overstretched banks taking marginally more than Italy's. [footnoteRef:10] The banks used these funds to buy government bonds, effectively easing the debt crisis. In February 2012, the ECB held a second three year auction of 529 billion to 800 European banks. Although the ECB program did not target specifically Italy, the country benefited through a temporary reduction of its borrowing costs. The ECB lent to euro area banks, which in turn lend to euro area governments, and then used the government debt they bought as collateral for yet more loans from the ECB. [10: ://www.bbc.co.uk/news/business-18058270]

Market instability in the euroarea and the unsustainable borrowing costs for countries such as Spain and Italy led to ECBs decision, announced on 6 September 2012, to purchase euroarea countries short-term bonds in the secondary markets, as part of the new program dubbed Outright Monetary Transactions (OMT). However, government from the beneficiaries countries were required to apply for aid from the euroarea rescue funds and to comply with conditions in exchange for the support. In the fall and early winter of 2012, Spain was considering whether to apply for this aid. The Spanish government, facing regional elections in the Basque Country, Galicia, and Catalonia, was keen to avoid the humiliation of requesting another bailout and having European authorities dictate the conditions of a rescue.

The Italian government has repeatedly ruled out the possibility of requesting EU financial assistance, pointing out that the economic situation of Italy was different from that of the countries that had requested EU financial assistance. The Italian authorities often highlighted the permanent risk of contagion, portraying Italy as a bystander in the crisis, and argued that the strengthening the euro zone is of collective interest (New York Times, 11 June 2012). At the EU level, in June 2012, together with the Spanish government, the Italian government called for and obtained the creation of an anti-spread shield, that is a mechanism to stabilize markets and to fix a ceiling for interest rates of so-called virtuous countries (Sole 24 Ore, 5 July 2012). The Italian Prime Minister made it clear; however, that Italy would not use the measure for the moment.


Despite the fact that Italy and Spain are often considered as belonging to the Mediterranean variety of capitalism, there are important differences in the way in which the crisis played out in these two countries. This is because a coherent variety of Mediterranean capitalism is missing and certain domestic political economy institutions namely, banks - that are key in order to explain the outcome of the sovereign debt crisis are overlooked by the literature on varieties of capitalism.

This analysis highlights the important role that banks had in the playing out of the crisis. Banks in Spain (to be precise, the cajas) turbo charged a property bubble. The implosion of this bubble in Spain, together with the dependence on wholesale market liabilities, and the depth of the economic crisis got the Spanish cajas into trouble, triggering a rather traditional banking crisis. The Spanish government did not have the fund to recapitalize these banks and had to resort to EU funds. Hence, the sovereign debt crisis in Spain was triggered by the banking crisis, worsened by a balance of payment crisis, which was caused by a high net foreign debt and sudden capital outflows. In both countries the accumulated loss of competitiveness worsened the current account deficit, which was however much larger in Spain than in Italy. Unlike Italy or Greece, at the outset of the crisis Spain had a strong fiscal position, hence the financial crisis in Spain originated from private sector overindebtedness (as in Ireland). The soaring public deficit and debt were largely a result of the banking crisis.

By contrast, Italian banks did not fuel property bubble and did not experience significant losses during the global financial crisis. It was the high level of debt (which increased, though not substantially, during the crisis) and the low level of growth that raised concern about the debt sustainability. Unlike in Spain, Italian banks were not instrumental in fostering significant capital inflows, making the country less vulnerable to a balance of payment crisis as a consequence of sudden capital outflows. All this explain why Spain had a fully-fledged sovereign debt crisis, resorting to EU financial aid, whereas Italy did not.

The Italian and Spanish experiences show the importance of domestic political economy institutions, to be precise of banks business models and regulatory/supervisory framework in the development of the two crises that conflated into the sovereign debt crisis. The collusion between local politicians and the management of the cajas proved to be a toxic mix for the Spanish banking system. Moreover, the cajas partly managed to escape regulation and supervision of the Banco de Espana. The Spanish commercial banks remained sound and profitable, and so did Italian banks. The main toxic product in the portfolio of Italian banks are currently Italian public bonds.


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