Sudden stops inside and outside the euro area - what a difference TARGET2 makes

During the Great Financial Crisis several European countries - both inside and out- side the euro area - suffered sharp reversals of private capital inflows. We examine how macroeconomic adjustments to sudden stops differ between members of the euro area and countries pegging the euro, the closest alternative to joining the euro. We focus on a key difference between a conventional euro peg and full euro membership: the quasi-automatic public financing of external deficits via the euro area payments system TARGET2. Our simulation results indicate that access to TARGET2 helps to mitigate the adverse effects of a sudden stop on output, consumption and investment, at least in the short run. As a drawback economic rebalancing is prolonged and accompanied by a considerable build-up of public debt. In contrast, euro peggers without access to public external finance suffer a sharp economic down- turn when subject to a sudden stop. On the upside, economic recovery is prompt and government debt remains stable. Estimation results for a group of euro area members and euro peggers are in line with our simulation results.