What lessons did we learn from the European debt crisis?
The first flush of youth
The early days of the single currency were smooth sailing and even much better than anticipated by certain economists who were sceptical about the idea of a European monetary union.[1]
By the mid-2000s, the stability brought about by the single European currency had strengthened economic and financial ties between member states: intra-European investment and trade had increased substantially, as had competition between firms, thanks to greater price transparency. Inflation differentials had narrowed and, as the ultimate marker of success, price stability had become a reality throughout the euro area. Against the favourable backdrop of the Great Moderation, the ECB succeeded in anchoring inflation expectations and thereby establishing its credibility.
However, in line with the “Walters Critique”, according to which a given monetary policy has expansionary effects in high-inflation countries (where demand is more dynamic) and restrictive effects in low-inflation countries (where demand is weaker), macroeconomic imbalances became entrenched.
The growth rates of euro area economies thus began to diverge sharply, as did their levels of – largely private - debt. Buoyed by a sharp fall in interest rates following their adoption of the euro, the Spanish and Irish economies enjoyed strong growth and a real estate boom. At the other end of the spectrum, the German economy went through a rough patch, weakened by reunification and a sclerotic labour market. In this macroeconomic context, the single monetary policy siphoned savings from northern Europe to the south, thereby creating major balance of payments asymmetries.
The widening of these imbalances raised many questions about competitiveness differentials. The imbalances, however, were partly attributable to the disappearance of exchange rate risks and the strengthening of financial integration. Likewise, the prevailing view was that fiscal policies had by and large improved and, although there was some discussion about weaker discipline following the introduction of the euro, there had been no harm done to the functioning of the EMU.
Overall, these divergences were not perceived as having a destabilising effect on the monetary union. They remained relatively modest, on the whole, by historical standards; few observers considered it necessary to correct them, and there were moreover few incentives to do so. However, things gradually took a very different turn in the wake of the global economic and financial crisis of 2008-2009.
The end of the age of innocence
In the aftermath of the collapse of the US bank Lehman Brothers on 15 September 2008, the money market was paralysed, a financial panic was in full swing and banking stocks around the world plummeted.
Initially, the euro was seen as a bulwark: it would protect euro area countries from global market volatility and preserve the functioning of the internal market.
Initially, the euro was seen as a bulwark: by rendering the possibility of speculation and competitive devaluation obsolete, it would protect euro area countries from global market volatility and preserve the functioning of the internal market. The currency crises of the 1990s appeared as nothing more than a distant memory. Centralised intervention by the European Central Bank ensured liquidity in the financial markets, and monetary policy easing was being transmitted smoothly to all euro area countries. Governments were taking on debt to support the economy, leaping to the rescue of banks and letting the automatic stabilisers play their role.
Subsequently, however, structural imbalances between countries painfully started to resurface, and the costs of sharing a single currency, i.e. the loss of monetary sovereignty and exchange rates as central instruments for macroeconomic stabilisation, began to take a toll.
In autumn 2009, the new Greek government announced that the country’s public finances were in much worse shape than previously reported. Over the course of 2010, investors wavered, and then panic set in. Interest rate spreads on the public debt of euro area countries rapidly widened, and concerns gradually spread to Ireland, Portugal, Spain and then Italy.
In Greece, sovereign insolvency weighed on the banking sector, while in Ireland and Spain, insolvent banks posed the main threat to public finances. Regardless of the source of the contagion, a vicious circle quickly developed: the government was responsible for rescuing banks, which were in effect financing the the state through their large holdings of public debt securities.
Starting in autumn 2011, a widespread crisis of confidence hit the so-called “peripheral” euro area countries and their banks. Speculation was rife, and the prospect of Greece going bankrupt and exiting the euro area was openly mooted.
Lessons from the crisis
The European sovereign debt crisis brought to the fore two major shortcomings in the design of the EMU: the lack of an effective centralised crisis management mechanism and the absence of a role for the ECB as public lender of last resort.
Under the European treaties, the national governments alone were responsible for the sound management of their public finances: neither the EU nor other member states could guarantee the debts of a member state (the so-called “no bail-out” clause). As the ECB could not lend directly to the member states (the “prohibition on monetary financing”), there were no provisions to allow sovereign crises to be managed in a coordinated way within the monetary union.
The member states borrow in a currency they do not control and are left to their own devices in the event of an acute crisis affecting their public finances.
In this context, the member states in effect borrow in a currency they do not control and are left to their own devices in the event of an acute crisis affecting their public finances. Unlike the US, they cannot rely on a central authority to ensure the stability of the financial system or to counter rising unemployment. And unlike countries with monetary sovereignty, such as the UK, they cannot, as a last resort, rely on their own central bank for sufficient liquidity.
The euro area was clearly facing an existential threat. Without a centralised financing mechanism, the member states were directly threatened by bankruptcy when financial turbulence worsened. And without the possibility to devalue their currencies, they would have no choice but to leave the monetary union or resort to internal devaluations - wage and price cuts - to regain competitiveness. However, such a deflationary environment makes it more difficult to repay debts, leading to a vicious circle of rising unemployment and an increased risk of bankruptcy.
Faced with the prospect of seeing the euro area split up, dragging the entire European project down with it, former ECB President Mario Draghi announced, in the summer of 2012, that the ECB would do “whatever it takes” to save the euro. The heads of state and government also took important measures that profoundly altered EMU governance. These actions will be discussed in a forthcoming article, which will shed light on how “complete” the EMU is today.
