Domestic Institutions or Systemic Forces? the Implications of Competing Explanations of the Eurozone’s Imbalances

Explanations of the financial imbalances that developed in the Eurozone following monetary union often focus on differences in domestic institutions: specifically public spending patterns and wage setting institutions. This paper takes issue with the adequacy of these explanations pointing to systemic effects on monetary union of financial flows within the Eurozone that help explain different demand, price and nominal wage dynamics across the Eurozone in the run-up to the euro crisis. Europe’s response to the crisis has been largely based on the traditional interpretation of the Eurozone’s imbalances. Understanding the role of financial markets and flows suggests that Europe’s imbalances cannot be pinned on domestic institutions. The paper ends by discussing the importance of understanding the systemic financial market characteristics of the Eurozone in evaluating the adequacy of its macro-economic response.