Current account imbalances or too much bank debt as the main driver of gross capital inflows? Spain during the Great Financial Crisis

Abstract

In contrast to the widespread view which posits that large current account deficits and net international debt were at the epicenter of the crisis in the Euro Zone, with diverging competitiveness playing a central role, this article points to the huge volume of bank credit that banks refinanced in international markets. With a focus on the Spanish economy, we ground our view in an analysis linking gross—not net—capital flows, bank credit, and gross external debt, which provides more adequate information about a country’s international financing patterns and its external exposure. The main conclusion of this article is that the principle driver of gross external debt in Spain was bank credit, with accumulated current account deficits accounting for less than 50 percent of gross external debt. Other consequences in keeping with this view are: the measures of economic policy required to sort out current account imbalances— particularly wage devaluation to improve competitiveness—may do more harm than good and they do not prevent the problem of too much bank credit from occurring again, and the residence of debt holders in the Euro Zone crisis is relevant for the understanding of the crisis as the result of a power imbalance.