Index

1. Introduction

2. The Origins of Cooperation in Europe

3. The European Monetary System

4. The Maastricht Treaty

5. The ERM crisis of 1992

6. Conditions for a Successful Currency Union

7. Reasons for Monetary Unification

8. Further Macroeconomic Benefits and Costs

9. The Euro Crisis

10. The Road Towards Recovery

11. Room for Improvement

12. The Underlying Crisis: External Imbalances

13. Solutions

14. Conclusions

References

Appendix: figures and tables

2

1. Introduction

The European Union as we know it today is the result of a long and

complicated process whose origins can be traced back to the years immediately

following the Second World War. The process that culminated in 2002 with the

introduction of a single currency has lately been at the centre of political debate in

all Member States, especially since the outbreak of the financial crisis of 2008. The

system, already proven vulnerable in the early Nineties, besides not yielding all of

the benefits forecast by its founding fathers, is now standing accused of having

actually aggravated the crisis acting as to spread it across Europe in the form of a

sovereign debt crisis.

A look to the origins and the high hopes that propelled a process spanning

over more than half of the previous century can provide a good starting point for a

discussion of the weaknesses and the strengths of the European Union and its role

in the 2010 crisis. Furthermore, based on similar experiences such as the Gold

Standard it is possible to individuate the main areas of improvement by comparing

how the same issues have impacted the other scenarios and what approaches were

adopted to address those issues.

3

2. The Origins of Cooperation in Europe

In an effort to prevent the outbreak of another conflict, six European

countries started to cooperate as early as 1950, following a plan designed by the

French Foreign Minister Robert Schuman. Germany, France, Italy, Luxembourg,

Belgium, and the Netherlands joined forces in 1951 in the European Coal and Steel

Community (ECSC), thus coordinating their heavy industries. This early cooperation

evolved into the European Economic Community and the European Atomic Energy

Community (Euratom), as stated by the Treaty of Rome of 1957. Leaving aside the

latter, which dealt specifically with issues related to the development of Europes

nuclear industries, the main idea behind the former was to create a common

market, which could allow the free movement of persons, goods, services, and

capital. This was to be achieved through the establishment of a customs union (Art.

3 of the Maastricht Treaty), the commitment of Member States to a common

agricultural policy, and the end of state intervention in the form of restrictive

agreements and aids that would interfere with the principle of free competition.

While the first regulations on the common agricultural policy entered into

force in 1962, it would take much longer for the idea of a common currency to be

applied: in particular, the first steps in that direction were taken in 1970, when the

Council appointed a committee of experts to propose ways of achieving economic

and monetary union. The report submitted by the experts the Werner Report

consisted of three steps to achieve free movement of capital, fixed exchange rates

and possibly a single currency by 1980. Starting the following year, Member States

were to coordinate their economic policies, especially their budgetary ones, with a

view to reducing excessive fluctuation of exchange rates. The achievement of this

task, conceived relying on fixed exchange rates against the dollar, was put at stake

when the US decided to float the dollar in 1971, leading to an appreciation of the

4

Deutschmark. In an attempt to counteract these rising divergences, 1972 saw the

implementation of the so-called snake in the tunnel system1, which allowed for

the currencies to fluctuate in narrow bands (+/- 1.25%) with respect to each other,

and in wider ones, provided for by the Smithsonian Agreement, with respect to the

US dollar. However, this newly-designed plan was aborted the following year due to

aggravating international macroeconomic conditions rising oil prices in particular

which forced some countries to abandon the parity against the US dollar.2

1 "Phase 2: the European Monetary System", 2010. 24 Jun. 2014 2 In the meanwhile, despite the initial failures, more European countries decided to join the

European Coal and Steel Community, whose members increased to nine in 1973 - when

Denmark, the United Kingdom, and Ireland joined -, and even further in 1981, with the arrival

of Greece, and in 1986, with Spain and Portugal. "Europa - The history of the European

Union", 2009. 28 Jun. 2014

5

3. The European Monetary System

A new attempt at coordinating macroeconomic policies was made in 1979,

with the establishment of the European Monetary System. The EMS included all

member countries currencies, except for the pound sterling. At the core of this

agreement there was the Exchange Rate Mechanism: a weighted average of the

Member States bilateral exchange rate indices made up a parity grid, to which

was associated a newly created basket currency, called European Currency Unit.

Bilateral exchange rates were allowed to fluctuate by 2.25% of the parity, with the

exception of the Italian Lira and the Spanish Peseta, which were allowed to vary by

as much as 6%. This second attempt, in which participating countries agreed to give

up some of their monetary autonomy, was more successful than the first one3:

exchange rates could now be changed only by mutual agreement of the interested

countries and the Commission, a fact that witnessed the emerging consensus

among in Europe on the importance of achieving price stability. There are, however,

controversial opinions regarding the causality links between the gradual

convergence of inflation rates among European countries and the establishment of

the European Monetary System. Eichengreen (1992) regressed CPI inflation data on

money growth, GDP growth, and inflation over preceding years for EMS and non-

EMS countries spanning from 1979 through 1990. The results showed very weak

significance, implying that EMS membership seemed to be meaningless for lowering

inflation4. Some argue5 that the context of general disinflation prevailing in Europe

at that time played a major role, allowing the system to survive - despite several

realignments - until 1992. In particular, it has been suggested that, starting in the

mid-Seventies, European countries committed to a monetarist approach to

3 See appendix, figure 1. 4 Eichengreen, 1992, p. 6. 5 Hodson, 2010, p. 161.

6

macroeconomic policies, focusing on the pursuit of low inflation by restricting

money supply growth, and in this context adhering to the ERM was seen as a

further way of achieving their goals6.

Anyway, whatever the underlying causes, the perceived success of the EMS

in the Eighties pushed the European Council to establish the Committee for the

Study of Economic and Monetary Union, which submitted a report in 1989 (the

Delors report) calling for a three-stage process to achieve a monetary union with

free mobility of capital, fully integrated financial markets, irrevocably fixed

exchange rates and irreversible convertibility of currencies, with a possible adoption

of a single currency in place of the various national currencies7. Under the first

stage, invoked also by the Single European Act of 1987, starting from 1990, the

internal market was completed, and restrictions on capital mobility were removed.

Furthermore, all Community currencies were included in the ERM under common

rules. The following stage required Member States to draft a new treaty, which

would provide a number of parameters aiming to:

coordinate macroeconomic policies between states;

set medium-term economic objectives and rules on the size of annual

budget deficits;

create the European System of Central Banks.

The new treaty envisaged by the Delors report was the Treaty on the European

Union, also known as the Maastricht Treaty, signed in 1991.

6 Hodson, 2010, p. 161. 7 Delors, 1989.

7

4. The Maastricht Treaty

The Treaty comprises a series of amendments to the previous international

agreements, thus pulling together the European Coal and Steel Community, the

European Economic Community, and the Euratom to form the European Union,

which is based on three pillars: the European Communities, the common foreign

and security policy, and police and judicial cooperation in criminal matters. The

provisions of the Treaty limit the authority of Member States, who assign specific

areas of competence to Community Institutions, sharing their sovereignty. The

Treaty also defines the role of European Institutions, such as the Parliament, the

Council, the Commission, the Court of Justice and the Court of Auditors, their term

and their relationship with each other, expanding the role of the European

Parliament and defining the procedures to be followed for the adoption and the

implementation of EU law. In matters of economic and monetary union, the

stepwise process originally outlined in the Delors report was defined in much the

same way, with the significant addition of the amendments to the original treaties

that were needed in order to make the provisions in the second and third stage

binding on Member States.

The final goal was the adoption of a single currency for all adhering countries,

and it was to be achieved through three stages, spanning throughout the Nineties:

1. liberalisation of capital movements towards the realization of a common

market, coordinating economic policies the process had begun in 1990,

and it should have reached completion by 1994 and the granting of

political independence to national central banks (Art. 108);

2. from 1994 to 1998, the establishment of the European Monetary Institute

which, together with the Council, had to report to the Commission on the

progress made in the fulfilment by the Member States of their obligations

8

regarding the achievement of economic and monetary union(Art. 109 j), i.e.

the fulfilment of the so-called Maastricht convergence criteria outlined in

the same article. The critical values were defined in Protocol 12 annexed to

the Treaty and in the Stability and Growth Pact, approved in 1997.

Table n. 1: The Maastricht convergence criteria

Price stability Measured by the harmonized consumer

price inflation rate, it shouldnt be

more than 1.5% above the value of the

three best performing Member States

Sound public finances The government deficit as a percentage

of GDP shouldnt exceed the value of

3%

Sustainable public finances The government debt shouldnt exceed

60% of GDP

Durability of convergence The long-term interest rate should be

no more than 2% above the value of

the three best performing Member

States in terms of price stability

Exchange rate stability Participation in the ERM for at least

two consecutive years without severe

deviations from the central rate.

Source: Hodson, 2010

9

Furthermore, according to article 109 f of the Treaty, the European

Monetary Institute had the following tasks:

strengthen co-operation between the national central banks;

strengthen the co-ordination of the monetary policies of the

Member States, with the aim of ensuring price stability;

monitor the functioning of the European Monetary System;

hold consultations concerning issues falling within the competence

of the national central banks and affecting the stability of financial

institutions and markets;

take over the tasks of the European Monetary Co-operation Fund,

which shall be dissolved; the modalities of dissolution are laid down

in the Statute of the EMI;

facilitate the use of the ECU and oversee its development, including

the smooth functioning of the ECU clearing system.

3. By 1999, the EMI had to be liquidated while the newborn European Central

Bank took over its functions (Art. 109 l). By that time, exchange rates had to

be irrevocably fixed.

10

5. The ERM crisis of 1992

The newly drafted system was hit the following year by a severe exchange

rate crisis which put at stake its very existence, despite the commitment of the

Member States. The first step towards European Monetary Union, i.e. the removal

of barriers to capital mobility in order to arrive at a common market, was

implemented starting from 1990. This was a significant difference with respect to

the EMS of the previous decade. As Eichengreen (1992) underlines, the EMS back

then was a hybrid of fixed and flexible exchange rates. Since the 1980s, exchange-

rate stability and low inflation let countries benefit from effects usually deriving

from fixed exchange rates. Periodic realignments (fifteen of them took place

between 1979 and 19928) would take care of asymmetric shocks and issues related

to competitiveness. This, however, was only made possible by the presence of

restrictions on capital movements, which sheltered the central banks reserves

against speculative attacks provoked by anticipations of a realignment.9 The

difference became more clear with the unification of Germany.

Massive public investments in Eastern Germany put inflationary pressures

on the Deutschmark, forcing the Bundesbank to increase interest rates. With no

capital controls, the other EMS countries were forced to import higher German

rates, which worsened the position of those who were facing a recession: such was

the case of the United Kingdom, of Spain, of Italy, whose fundamentals displayed

falling economic growth and rising public debt, and of France, where

unemployment figures were rising. The situation deteriorated further in 1992 when

Denmark rejected the Maastricht Treaty, and polls claimed France was going to

follow. Investors began to speculate on devaluations in the weaker countries, in

particular the United Kingdom, Italy, Spain and France. Capital started flowing out

8 Montiel, 2009, p. 447. 9 Eichengreen, 1992, p. 8.

11

from those countries and into Germany. Choosing to sacrifice external equilibrium

(the parity with the Deutschmark) in favour of internal economic objectives, the

United Kingdom, Spain, and Italy dropped out of the ERM in 1992. France was able

to face the speculative pressures without retreating, but those resulted in wide

exchange rate fluctuations (+/- 15%)10. Only after some years of economic recovery,

marked by large margins of fluctuation, most countries were able to meet the

Maastricht criteria in order to proceed towards monetary unification11. Despite

these difficulties, in 1998 the Council examined the fundamentals of the Member

States: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy,

Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the United Kingdom

were deemed to have fulfilled the Maastricht requirements; only Greece was not.

The inclusion of Italy and Belgium was a controversial one, since their public debt

was exceeding 100% of GDP12. Despite qualifying, Sweden, Denmark, and the

United Kingdom decided not to join the EMU in 1999.

Thus, only eleven of the fifteen original countries participated initially to the

EMU in 1999. Their currencies were irrevocably locked with fixed exchange rates.

Following the plan, the ECB took the place of the EMI and started to dictate

monetary policy for the European Union. On January 1st, 1999 the Euro became the

official unit of account, but it only started circulating, alongside national currencies,

in 200213.

10 Montiel, 2009, p. 449. 11 Hodson, 2010, p. 163. 12 Montiel, 2009, p. 449. 13 See appendix, figures 1, 2, 3.

12

6. Conditions for a Successful Currency Union

Before running an ex post analysis of the costs and benefits of the EU, it is

useful to understand whether, based on the theory, such a union could have been

feasible in present-day Europe, and what conditions could have made it better. It

has already been noted that the preconditions required by the Maastricht Treaty

werent met by all of the founding members of the European Monetary Union. In

the early Nineties, some even suggested the EMU should start only with a subset of

EC members, namely the only seven who could plausibly satisfy all the convergence

criteria by 199714. However, according to Eichengreen (1992), this option was

rejected as the benefits from the adoption of a single currency tend to increase the

more countries participate; rather than starting with a smaller union, EC members

chose to extend the waiting period until more of them came closer to meeting the

requirements.

Besides the convergence criteria, other prerequisites affecting the overall

benefits and costs of monetary unification are necessary for a successful currency

union. De Grauwe (2012 a) develops a critique of the theory of optimum currency

areas testing the views held by the European Commission in the Nineties.

The first point of such critique concerns the relevance of differences among

countries trade structure and what will this imply in the case of demand shocks.

The Commission held the view that most demand shocks would impact different

countries in similar ways because the removal of barriers and the completion of the

single market would lead to a similar structure of trade across the Euro zone. Since

trade between industrial European nations is to a great extent intra-industry trade,

a higher degree of trade integration will cause less asymmetric shocks, and more

symmetry in the movements of output and employment for countries in the union.

14 Namely, the Netherlands, France, the United Kingdom, Spain, Luxembourg, Germany, Denmark, and Portugal. See Eichengreen, 1992, p. 52-55.

13

The higher the degree of industry similarity between Member States, the better the

effect of a monetary union, which will then tend to make income and employment

more correlated between countries involved. This relationship would be reversed if

Europe were to move away from industrial similarity towards regional

specialization. This second scenario finds support in data from the early Nineties,

which show that the correlation of disturbances - both in the case of temporary and

permanent ones - of Economic Community countries with those of Germany is

rather low. The findings suggest that shocks in Europe are relatively idiosyncratic15,

making the case against the adoption of a single currency. However, later studies

revealed that as economic integration in Europe increased, the business cycles of

European countries became more correlated16. The issue remained controversial

until the outbreak of the current crisis, which forced the European policymakers to

intervene, only to realize that a unique remedy wasnt going to work for the whole

union, especially if the countries who gained the most from unification werent

willing to make some sacrifices to help those in need17.

Another point at issue concerns the fact that countries who decide to join a

currency union automatically give up some of their powers. Adopting a single

currency in common with other states implies losing control over monetary policy

and exchange rate policy. States are left free to decide only on matters concerning

their budgetary and fiscal policies which, some argue, may become a further

source of asymmetric disturbances18. Therefore, in case of shocks, the mechanisms

to restore equilibrium rely on labour mobility, wage-price adjustments, inter-

regional flows of capital be it private or public , and fiscal transfers19. A

successful currency union should then rely on:

15 Eichengreen, 1992, p. 14. 16 De Grauwe, 2012 a, p. 27. 17 Eichengreen, 2010, De Grauwe, 2012 b, De Grauwe and Sngas, 2003. 18 De Grauwe, 2012 a, p. 31. 19 Eichengreen, 1992, p. 16.

14

high labour market flexibility. Drawing comparisons from the United States

labour market, De Grauwe (2012 a) and Eichengreen (1992) suggest that this

is not the case for an EU consisting of 15 countries, and even less so for the

present-day EU-27.

the presence of a system of fiscal transfers to provide relief in case of

asymmetric shocks, both for real and financial shocks, as is the case in the

United States20. Completing the monetary union with a budgetary one

lowers dramatically its costs. This, however, implies the need for a stronger

political union, which is lacking in Europe.

Based on the above criteria, De Grauwe (2012 a) claims the EU doesnt

constitute a successful currency union. This is partly due to the heterogeneity of

each countrys position, which doesnt allow to draw a unique scheme benefiting

all. Data suggests that only a subset of EU countries could form an optimal currency

area, including Germany, the Benelux countries, Austria, and France. Enlarging the

union any further may result in economic costs exceeding the advantages for

participants.

20 Eichengreen, 1992, De Grauwe, 2012 a.

15

7. Reasons for Monetary Unification

Despite all the unfavourable forecasts and several doubts regarding the

possibility of building a successful union, European legislators still opted for

monetary integration in Europe, displaying a surprisingly strong willingness to

follow the predetermined path, and being mainly concerned with the following

three objectives21:

the elimination of exchange rate uncertainty aiming at increasing intra-

European trade;

enhancing Europes role in the world monetary system;

making the cost of managing the Common Agricultural Policy affordable.

How did the European Union perform with respect to the achievement of the above

goals?

7.1 Eliminating exchange rate uncertainty

The first objective should benefit consumers at the microeconomic level,

lowering the costs deriving from exchanging one currency into another, while at the

same time it should help trade and international investments, getting rid of the

deadweight loss represented by the transaction costs22 and of the exchange rate

risk23. The European Commission provided an estimation of the direct gains in its

1990 report One Market, One Money: an evaluation of the potential benefits and

costs of forming an economic and monetary union. The yearly estimates of the

entity of such savings range between 13 and 20 billion Euros; put in relative terms,

it amounts to 0.25 to 0.50% of the Community GDP24. Nowadays the figures would

probably be even smaller due to a wider use of electronic payments, which bypass

21 Montiel, 2009, p. 446. 22 De Grauwe, 2012 a, p. 55. 23 Eichengreen, 1992. 24 De Grauwe, 2012 a, p. 55.

16

the currency conversion issue. Furthermore, the evidence for an increase in intra-

European trade or investment is scanty: despite the obvious welfare gains from the

elimination of the exchange rate uncertainty and the minimization of the inflation

risk25, the use of different currencies need not pose a limit to the trade of goods or

services, as there already exist other means of hedging the exchange rate risk, such

as currency diversification, or forward markets26.

Nonetheless, the elimination of transaction costs brings about also

intangible benefits, such as price transparency. Consumers are supposed to be

facilitated in the comparison of prices since now these are all expressed in the same

currency. This should increase competition, resulting in prices converging to the

lowest value within the Community, and benefits for the consumers. However, as

De Grauwe (2012 a) points out, price discrimination is widely practiced in the

European Union, since most consumers are unlikely to move to a different country

to take advantage of lower prices there. Furthermore, data show that price

convergence - occurring in the early 1990 - disappeared since the launch of the Euro

zone27.

7.2 Enhancing Europes role in the world monetary system

The 1990 EC Commission report One Market, One Money makes a point of

demonstrating the impact on growth of the elimination of the exchange rate risk. In

the minds of the European legislators, who were conducting the analysis on a

neoclassical growth model, lower or no exchange rate risk should decrease the

systemic risk, which in turn will lower the real interest rate and shift the economy to

25 De Grauwe, 2012 a, p. 58. 26 Eichengreen, 1992, p. 8. 27 De Grauwe, 2012 a, p. 56, 57.

17

a new equilibrium level, resulting in an accumulation of capital and a transitional

increase in the growth rate, reaching higher output and capital per worker28.

However, when confronted with data, this theory does not seem to hold.

Comparing the growth rate in the Euro area before and after 1999, one finds little

to no evidence of positive effects of the Euro on growth. On the other hand, there is

also little evidence that the adoption of the Euro caused a slowdown in the growth,

confirming the principle of monetary neutrality in the long run29. This mismatch

between theoretical predictions and actual outcomes is probably due to the fact

that the elimination of exchange rate risk did not bring about significant decreases

in the real interest rate, with the exception of Ireland, Spain, Portugal, and Greece.

Ireland, Spain, and Greece actually saw a temporary acceleration of growth, as

predicted by the theory.30

7.3 Making the cost of managing the Common Agricultural Policy affordable

The Common Agricultural Policy was implemented starting in 1962, giving

Member States joint control over the food production. European farmers were

granted the same, fixed price for their produce. Of course, the prices were fixed in

terms of domestic currency, so insofar as exchange rates were not fixed, there was

an incentive for markets to speculate on the price of commodities, shipping them

from one country to another and disrupting efforts to maintain an orderly

market.31 Fixing exchange rates prevented speculation from happening while

granting food safety for the citizens of the Union and decent earnings for farmers32.

28 EC Commission, 1990, p. 78-81. 29 De Grauwe, 2012 a, p. 65. 30 De Grauwe, 2012 a, p. 65. 31 Eichengreen, 1992, p. 9. 32 "The history of the CAP - Agriculture and rural development." 2012. 29 Jun. 2014

18

8. Further Macroeconomic Benefits and Costs

Whether the objectives listed above have been fully attained or not, joining

the European Monetary Union implied several other consequences. Among the

gains, even if their effect is disputed, countries who entered the Union, besides

becoming part of a stronger international political entity, could efficiently and

effectively curb inflation, while maintaining some exchange rate discipline, as

shown by the EMS in the Eighties. Even more so when the soft pegs of the EMS

were replaced by the fixed exchange rates provided for under the Maastricht

Treaty: once monetary unification was achieved, in order to take full advantage of

its positive effects, participating countries had to commit credibly to it. This implies

that, as Eichengreen (2010) notices, neither the Maastricht Treaty nor its later

updates - i.e. the Treaties signed in Amsterdam (1997), Nice (2001), and Lisbon

(2007) - consider an exit procedure for a country willing to drop out of the

European Union. European leaders needed their efforts to appear credible and

permanent, whereas including clauses of that kind might have severe destabilizing

effects: it would end up paving the way for self-fulfilling crises if markets were to

start betting on a countrys exit33.

Therefore, joining the European Monetary Union meant that sovereign

countries had to give up permanently their exchange rate and monetary policies,

which became a matter of competence of the ECB. Furthermore, having to respect

the Maastricht criteria and the Stability and Growth Pact implied also a limited

scope of action in matters of fiscal policy. The European Central Bank was instituted

with the specific task of maintaining price stability, and not as a lender of last

resort34. This concept was embedded in the Stability and Growth Pact as well as in

the Maastricht criteria, in order to prevent single Member States from running

33 Eichengreen, 2010, p. 17. 34 Maastricht Treaty, Art. 105.

19

overly expansionary fiscal policies and then pressing the ECB to buy their national

debt. Once the monetary union was in force, the bad behaviour of one of the

members would take its toll on the rest of them. If indebted states were to ask the

ECB to bail them out, and if the ECB actually did so, then the remaining countries

would end up having to repay somebody elses debts in the form of inflation, or in

the form of a higher tax burden, or with higher interest rates35. State sovereignty in

matter of fiscal policy was further reduced in 2011 with the approval of the so-

called Fiscal Compact, a treaty imposing tighter budget constraints and sanctions

for countries that do not respect the Maastricht criteria36. Trapped within such

narrow bounds, individual states have very little room for action left in case of

asymmetric shocks which nonetheless may still occur. As seen earlier, the only

adjustment mechanisms in place rely on the adjustment of prices and wages, the

mobility of labour, capital flows, and fiscal transfers37.

With regard to the first channel, problems arise from the fact that, due to a

number of factors encompassing differences in the taxation of labour and high

unionization of workers, wages in Europe are rather rigid and slow to adjust38. At

the same time, the presence of a number of barriers like language and cultural

differences, or differences in legal systems e. g. in case of mandatory licences or

permits, or the lack of harmonization of the school systems , slow down the

mobility of labour, which was already traditionally low within single states,

especially in the southern periphery of the European Union39. The result was the

deterioration of these countries competitive position as measured by the

increase in the relative unit labour costs of southern Member States compared to

35 Eichengreen, 1992, p. 28. 36 "Six-pack? Two-pack? Fiscal compact? A short guide to the new EU fiscal governance", 2012. 29 Jun. 2014 37 Eichengreen, 1992, De Grauwe, 2012 a. 38 Eichengreen, 1992, De Grauwe, 2012 a. 39 Eichengreen, 1992.

20

core countries 40. As De Grauwe (2012 b) shows, it would take a series of internal

devaluations, coming at a great cost in terms of lost output and employment in

countries such as Greece, Ireland, Spain, Italy, and Portugal. The same author went

even further, claiming that internal devaluations in the PIIGS countries are less

costly when the surplus countries are willing to allow for internal revaluations. (De

Grauwe, 2012 b; see also appendix, figures 4, 6, and table 2)41

Thus, ruling the first two mechanisms out of the picture, it must be kept in

mind that the unification of financial markets allows free mobility of capital across

the union. However, some devaluation risk will always be present to discourage

capital inflows towards countries experiencing recessionary dynamics42. This

became particularly evident during the Euro crisis that hit the European Union in

2010-201143.

40 De Grauwe, 2012 a. 41 The same conclusion, on a theoretical level, is reached by Eggertson and Krugman, 2012. 42 Eichengreen, 1992, p. 24, 25. 43 De Grauwe, 2010.

21

9. The Euro Crisis

The downturn that hit the Euro zone in 2010 is often referred to as a debt

crisis. However, the overall level of debt in the EU as a percentage of GDP wasnt

even nearly as high as the debt in the United States: the value of the general

government consolidated debt for the US in 2010 was approaching 95%, about ten

percentage points above the aggregate level of the EU with 16 Members44.

Nonetheless, it is the Euro zone that was severely hit by the crisis, which soon

became the main topic of political debate and began raising questions regarding the

opportunity for some countries to continue to take part in it.

The overall low level of debt for the EU as a whole actually hides huge

differences in each countrys level of debt45. Nonetheless, except for Greece, the

overall trend in the years before 2008 in compliance with the convergence criteria

, was that of a decrease of public debt. However, after the economic downturn of

2008, the scenario worsened dramatically: on one hand, national budgets came

under strain because, as the recession set in, the decline in government tax

revenues was faced by an increase in the expenditure on social programs to ease

the recovery; on the other hand, public governments were often called in to

guarantee solvency for private debtors, and did so by issuing national debt46.

This was the situation in 2010, when Dubai unexpectedly postponed the

repayment of its bonds. The event caught the markets and the rating agencies

completely off-guard. Consequently, investors became extremely sensitive to the

risk of default on sovereign debt. Rating agencies were quick to look for more

potential culprits, downgrading Greek bonds first, and then those of several other

southern European countries. This ended up amplifying the destabilizing effects of

44 See appendix, figure 7. 45 See appendix, figure 8. 46 De Grauwe, 2010.

22

financial markets, where investors started to look for adequate compensation in

terms of higher interest rates for what was suddenly perceived as a huge risk47. The

countries with the highest level of debt were penalized with huge interest charges

while capital fled into less indebted countries, such as Germany. These states, who

became known as virtuous countries, took advantage of the situation, which

allowed them to borrow lots of capital on the markets at very convenient rates. In

the meanwhile, the cost of servicing the debt became unbearable for southern

European countries, and intervention was called for at the European and

international level in order to restore equilibrium.

47 De Grauwe, 2010; see appendix, figures 5 and 9.

23

10. The Road Towards Recovery

The crisis could have been stopped soon after its eruption by bailing out

Greece48. As a matter of fact, the divergence in the interest rates on long term

government bonds did indeed start to decrease in 2012, when the ECB

implemented its OMT Outright Monetary Transactions program, pledging to buy

unlimited amounts of European sovereign debt in order to reassure the markets49.

It took two years, however, for the ECB to intervene, mainly due to disagreements

among Eurozone governments on the right actions to be taken50. A quick

intervention was needed in order to give markets a form of reassurance with regard

to the solvency of a Member State, thus preventing the contagion to other

countries in similar positions. In addition to this, falling prices of bonds could have

severely hurt banks, who were recovering from the 2008 downturn by exploiting

the high rates on long-term government bonds. Moreover, De Grauwe (2010)

further argued that delayed intervention in Greece would have protracted the rise

in the yield of government bonds, a fact that translated into huge costs for the

servicing of the debt. Pressed by the markets, the governments would be forced to

enact extraordinary measures, contracting fiscal policies, leading to deflationary

pressures51 and risk pulling down the EU in a deeper recession following the

dynamics of the Fisher paradox52. The previous prediction turned out to be rather

accurate: the ECBs procrastination, which was protracted even further due to the

political disagreement of governments on the matter, reduced the effect of the

authorities reassurances and the credibility of the intervention itself, not only

falling short of the goal of stopping the crisis, but even worsening it. In the end, it

48 De Grauwe, 2010. 49 De Grauwe, 2014, see also appendix, figure 5. 50 De Grauwe, 2014. 51 De Grauwe, 2010. 52 See appendix, figures 11 and 12.

24

created an asymmetric adjustment mechanism, in which most of the burden was

carried by the debtor nations, who have been imposed a strict rule of austerity

without any compensating stimulus by the creditor nations53. As predicted, this

resulted in deflationary pressures for debtor countries, that can be seen from the

change in the relative unit labour costs: they were soaring for debtor countries until

2008-2009, testifying a worsening of their competitive position, and then started

dropping, more severely for Ireland, Greece, and Spain. These dynamics havent

been observed for creditor countries, where relative unit labour costs remained

almost constant for the period in line with the average from 1970 to 201054.

Despite these harsh remedies, there is no evidence that they will actually be

effective in improving countries ability to repay their debts; on the contrary, the

position of debtor countries actually worsened55. Data suggests that the stronger

the austerity program, the heavier its toll on a countrys GDP, and therefore on the

debt-to-GDP ratio56. In such a recessionary scenario, for their position to become

sustainable, countries such as Italy, Greece, Portugal, Ireland, and Spain would have

to significantly increase their exports, while at the same time keeping on growing: a

nearly impossible target, especially given the impossibility of exploiting exchange

rate devaluations.

53 De Grauwe, 2012 b and 2014, Eggertson, 2012. 54 De Grauwe, 2012 b; see appendix, figure 6. 55 This follows closely the Fisher paradox, as reported also by Eggertson and Krugman, 2012. 56 De Grauwe, 2014. See appendix, figures 10 and 11.

25

11. Room for Improvement

The crisis merely exposed the structural weaknesses that policymakers had

neglected to recognize and correct while still in time to do so. They have been

warned about the need to foster coordination of fiscal policies across the union, a

concept that was warmly suggested by the Maastricht treaty, but, as Eichengreen

forecast in 1992 and later observed , lacked substantial implementation57.

Besides the problems that have been examined so far which can be

summarized by admitting that the Euro-15 does not constitute an optimal currency

area , the Euro crisis was fuelled by two design failures, which concern mainly two

points58.

1. The monetary union is fully centralized, while macroeconomic policies are

conducted at the national level. When business cycles, which are not constrained by

the single monetary policy, generate periods of recession in a region, then

monetary policy has no way of intervening on that specific area. In this kind of

setting, having only one policy interest rate for the whole union may even aggravate

cyclic booms and recessions. Without a supranational fiscal authority that could

compensate for local asymmetric shocks, prices and wage adjustments, together

with labour migrations, have proven insufficient to take care of the job59.

2. The lack of safety nets and, more importantly, the absence of a budgetary union

to support the monetary union. This implies that crises like the one of 2010 are

likely to occur again because Member States issue debt in a currency they have no

57 Eichengreen, 1992, and 2010, p. 19. 58 De Grauwe, 2012 a, and 2014. 59 De Grauwe and Sngas, 2003.

26

direct control over60. Even more so considering the design of the ECB: given its

complete autonomy from the governments, they have no power to force it to

provide liquidity, even during a crisis. Therefore, the EU currently sees in force a

primacy of the Central Bank over the governments - unlike in the United States61.

This translates into the supremacy of non-elected officials at the ECB, who decide

upon the fate of democratically elected governments by deciding whether to act as

a lender of last resort or not62.

60 De Grauwe, 2012 a, p.114, and 2012 b. 61 Eichengreen, 1992, p. 45. 62 De Grauwe, 2014.

27

12. The Underlying Crisis: external imbalances

Eurostat data for the period immediately preceding the 2010 crisis suggests

the Euro zone countries were far from being in balance even back then63. The

problem of external imbalances in the Balance of Payments of Member States has

been underestimated for a while, and even the Maastricht Treaty didnt consider

the issue as one worth worrying about, unless it concerned countries who meant to

join the EU. The official stance on the problem, however, almost completely

disregarded individual countries Balance of Payments while focusing on the

balance of payments of the union as a whole which, indeed, was in equilibrium.

Nevertheless, according to a recent analysis64, a misalignment of internal real

exchange rates, coupled with the lower interest rates in force right after the

introduction of the Euro, allowed peripheral countries to obtain cheap credit to

finance their private and public deficits. This caused capital to flow out of PIIGS

countries, who exhibited increasingly negative Balances of Payments, and into

centre-European countries, who ended up funding the formers BoP deficits. This is

supported also by data on the values of TARGET2 balances, i.e. the balances of the

Euro area interbank payment system, representing the claims and the liabilities of

the National Central Banks to the ECB. For the period going from 2007 to 2011,

these show plenty of liquidity accumulating in central European countries, flowing

in from southern peripheral ones65.

63 See appendix, figure 12. 64 Mayer, Mbert, and Weistroffer, 2011; Mayer and Bttcher, 2011. 65 See appendix, figure 13.

28

13. Solutions

Krugman (2012), De Grauwe (2012 b), Eichengreen (2010), among others66,

seem to agree that the only way out of a similar situation involves a collaboration

between debtor and creditor countries. The first step in this direction would be an

increase in spending by the creditor countries, so as to turn their BoP surplus into a

deficit. An additional option yielding similar outcomes would imply an internal

devaluation by debtor countries in order to boost exports. As a result of the first

two steps, creditor countries would have to cope with some more inflation and the

creation of excessive reserve money, as deficit countries obtain central bank

money from the ECB to fund their balance of payment deficits.67 These solutions,

however, are not being implemented in a symmetric way; instead, lots of pressure

is put on debtor countries, who feel left out from the decision process68. For

example, debtor countries in most cases have indeed undergone a process of

internal devaluation, bearing huge social costs, while surplus countries did not allow

any significant internal revaluation69.

This problem is a direct legacy of the Euro crisis. To prevent situations of

stalemate such as the one right after the Greek debt downgrading, the ECB and the

Commission have been assigned wider powers and responsibilities the latter can

now impose changes in taxation and budgetary policies, and should monitor and

correct macroeconomic imbalances in the framework of the Macroeconomic

Imbalance Procedure -, but these came without greater accountability70. The

European Central Banks and the Commissions decisions can affect the lives of

millions of European citizens, who in turn do not have a say on the matter, and thus

66 See also Mayer, Mbert, and Weistroffer, 2011, and Mayer and Bttcher, 2011. 67 Mayer and Bttcher, 2011. 68 De Grauwe, 2012 b, and 2014. 69 De Grauwe, 2012 b. 70 De Grauwe, 2014.

29

feel excluded from the decision making process while being forced to bear its social

and economic consequences71.

71 De Grauwe, 2014.

30

14. Conclusions

In an analysis of the then newly drafted Maastricht Treaty, Eichengreen

(1992) expressed his doubts with regard to the possibility of building a currency

union in Europe. Already back then, data suggested it was not the case of an

optimal currency area, and nowadays it appears that he might not have been

wrong. It has been noted how many of the problems he forecast actually showed up

recently. His and De Grauwes (2014) comments on the Treaty leave very few things

unsaid. The two suggested European policymakers to work on fixing a number of

mistakes by directly modifying the Maastricht Treaty, and in particular:

allocate more clearly responsibility for exchange-rate policy and facilitate

policy coordination at G7 summits. In the years preceding the crisis,

European political leaders would meet in Brussels to discuss common

policies which they wouldnt implement in their own countries, caring more

about internal consensus than about the health of the European economy72.

Like during the Great Depression, indebted countries (Germany and Austria

then; Italy, Portugal, Greece, and also the US now) were in such position also

because of the policies adopted by countries experiencing a surplus (the US

and France in the 1930s, China and Germany nowadays)73. Adjustment

would be easier, faster, and less painful in terms of shocks to output and

unemployment for debtors if creditors adopted expansionary fiscal

policies74. Since the latest crisis, the Macroeconomic Imbalance Procedure

has been set up, monitoring a number of macroeconomic variables such as

current account balances, competitiveness measures, house prices, and

72 Eichengreen, 1992. 73 Eighengreen, 1994. 74 Eichengreen, 2010.

31

bank credit. However, there is still more to be done: the need to prove to

markets the credibility of the commitment to the Union might force

Members to issue eurobonds75. Such an issue of debt would make

participating countries jointly liable. At the same time, though, it would

bring about moral hazard issues; it is therefore understandable that this

proposal has met stiff resistance.76

Safeguard the political independence of the ECB, but at the same time keep

in mind that the impossibility for governments to influence its actions has

proven a triggering issue in the latest crisis77. One of the key features of the

Gold Standard, which some claim to be the reason of its initial success, was

the independence of the banking sector from political powers; besides this,

and strictly following from it, that regime also featured a strong role played

by the Bank of England78, which has been matched only in recent years by

the ECB. However, its recent policy developments, and especially forcing

austerity upon the sinners79, are a mere replication of the mistakes made

in the previous century, which led to the Great Depression80.

Set up a more extensive system of regional coinsurance to help absorb

asymmetric shocks. Another parallel can be drawn with the Gold Standard

on this field. Actually, both downturns highlighted the importance of lenders

of last resort in order to act quickly on impending dangers. This kind of

institutions hadnt been properly designed also during the Gold Standard

75 De Grauwe, 2012 b. 76 De Grauwe, 2012 a, p.125. 77 De Grauwe, 2014. 78 Eichengreen, 2010. 79 De Grauwe, 2014. 80 Eichengreen, 1994, 2002, and 2010.

32

era, condemning Austria to a harsh recession.81 In 2010, when Greece was in

need of financial help, the European Union wasnt able to provide any.

Therefore, Greece had to ask the IMF for relief, sparking debate on whether

the IMF should intervene on what was considered as an internal matter. To

respond to such emergencies, the European Financial Stabilization

Mechanism (EFSM) and the European Financial Stability Facility (EFSF) were

established82.

The solutions to the problems brought up by the Euro crisis are being

implemented, but the healing process is far from being a straightforward one. On

one side, the implementation of these political measures is at odds with the

principle of subsidiarity, i.e. it impacts the sovereignty of Member States because it

requires a redefinition of community versus state competencies83. On the other

hand, the crisis has shown that single Member States arent that willing to sacrifice

their economic interest for the sake of the European Union84. This last observation

is, by all means, the biggest issue for the European Union: the absence of a strong

political union, and the lack of a firm idea of commitment to a common cause85.

Without a stronger political union which cannot be achieved only by

strengthening the bureaucratic union the Euro will remain nothing but a currency

without a country, and that makes the Euro zone unsustainable in the long run.86

81 Eichengreen, 2000, and 2010. 82 "Financial assistance in EU Member States - European ..." 2012. 29 Jun. 2014

83 Eichengreen, 1992. 84 De Grauwe, 2014. 85 De Grauwe, 2012 a, p. 132. 86 De Grauwe, 2014.

33

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36

Appendix: figures and tables

Figure 1: CPI inflation in the Eurozone. (Source: Montiel, 2009, p. 450)

Figure 2: long-term interest rate (government bond yield). (Source: Montiel, 2009, p. 450)

37

Figure 3: Public debt. (Source: Montiel, 2009, p. 451)

Figure 4: Relative unit labour costs for PIIGS countries. (Source: De Grauwe, 2012 b)

38

Table 2: Internal devaluation in PIIGS countries. (Source: De Grauwe, 2012 b)

Figure 5: (Source: De Grauwe, 2014)

39

Figure 6: Relative unit labour costs in core European countries. (Source: De Grauwe, 2012 b)

Figure 7: General government consolidated gross debt as a percentage of GDP. (Source: European Commission, AMECO)

40

Figure 8: General government consolidated gross debt as a percentage of GDP. (Source: European Commission, AMECO)

Figure 9: Interest rate spread over German bonds. (Source: OECD.stat)

41

Figure 10: The Fisher mechanism. (Source: De Grauwe, 2014)

Figure 11: The Fisher mechanism. (Source: De Grauwe, 2014)

42

Figure 12: Current account balances in EU. (Source: De Grauwe, 2014)

Figure 13: Target 2 balances of NCBs, in EUR billions. (Source: ECB Monthly bulletin, Oct. 2011, p. 36)