Capital Flows and the Eurozone Crisis-Implications for Economic Policy

Historical experience shows that one of the root causes of financial crises are the periods of high capital mobility. A significant number of authors agree that in the world of high capital mobility, sudden stops of capital inflows may occur, typically triggering financial crises. The latest financial crisis in the euro zone (EZ) seems to support this point of view. Euro adoption encouraged a capital flow bonanza to EZ periphery (Greece, Portugal, Ireland Spain). The sudden stop which happened in 2009, made it difficult for this countries to roll over debt, and thus caused a crisis. This paper analyses the role of large capital inflows in generating the EZ crisis. It consists of three parts. The first part describes the episodes of so called “capital account crises” in the emerging markets, which occurred during the several past decades. The second part focuses on the impact of capital flows on the latest EU crisis. In this this part it is statistically documented that the crisis in the EZ has not occurred only as a result of fiscal indiscipline of some member states, as it is usually believed, but have also been a result of external, systemic reasons, such as the large capital flows. The third part recommends some measures of economic policy which could act as prevention in a situation of reappearance of great capital inflows in the EZ periphery. Not only could the actual EU member states benefit from these policy measures, but the potential candidates, such as the Republic of Macedonia as well. After a few years, investors will maybe regain confidence and once more try to seek the higher returns that are available in periphery countries. And the recipients of the resulting capital flows will once again be vulnerable to sudden stops. Key words: financial crisis, sudden stops, capital flows, EZ, recessio