How can the euro area crisis be solved in the long run?

Master's Thesis 2017 142 Pages

Business economics - Economic Policy


Table of Contents


Table of graphs

1 Introduction

2 Origins of the euro area crisis
2.1 Theory: Optimum currency areas
2.2 Design flaws in the EMU

3 Rescue operations and structural reforms: what was done to prevent the break-up of the eurozone?
3.1 Macroeconomic (rescue) measures
3.2 Monetary Policy
3.3 Banking Union

4 Assessment and problems still to be solved
4.1 Macroeconomic measures
4.2 Monetary Policy
4.3 Banking Union
4.4 Competitiveness levels
4.5 Further obstacles and problems
4.6 Interim Conclusion

5 Proposals
5.1 Proposals including more integration in the eurozone
5.2 Proposals including more individual responsibility and/or less integration in the eurozone

6 Assessment

7 Conclusion


List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of Graphs

Graph 1: Nominal Unit Labor Costs (1999=100; per person; total economy)

Graph 2: Real Unit Labor Costs (1999=100; per person; total economy)

Graph 3: Average inflation rates (GDP deflator), 2000-2008

Graph 4: Real Labor Productivity (per person, 1999=100)

Graph 5: Total R&D expenditure (in % of GDP)

Graph 6: Current Account Balance (in % of GDP)

Graph 7: Consolidated Gross National Debt (in % of GDP)

Graph 8: Annual government deficit (in % of GDP)

Graph 9: Ten-year government bond rates

Graph 10: Ten-year government bond rates

Graph 11: Consolidated Gross National Debt (in % of GDP)

Graph 12: Domestic sovereign debt holdings of MFIs as a percentage of total assets

Graph 13: Inflation rate (Annual average rate of change; All-items HICP; Euro area 19)

Graph 14: ECB interest rates and the overnight interest rate (percentages per annum)

Graph 15: Gross Domestic Product (at market prices; chain linked volumes, index 2010=100)

Graph 16: Real Unit Labor Costs (1999=100)

Graph 17: Average inflation rates (GDP deflator), 2010-2016

Graph 18: Current Account Balance (in % of GDP)

Graph 19: Real Labor Productivity (per person, 1999=100)

Graph 20: Total R&D Expenditure (in % of GDP)

1 Introduction

„If the Euro fails, Europe fails“
Angela Merkel, German Chancellor (2010).

When Chancellor Merkel (Deutscher Bundestag 2010) emphasized the paramount importance of the Monetary Union for Europe with the above sentence in 2010, she intended to justify rescue measures to the extent of hundreds of billions of Euros to safe the eurozone. Albeit it may be controversial to link the future of a whole continent to the persistence of a currency, it is rather unequivocal that major efforts were necessary to prevent the break-up of the euro area. Eventful years have passed by since then, with countless seeming crisis summits, reform efforts that did not yield the desired success, political conflicts, social turmoil, emerging anti-Euro parties and crisis peaks in 2012 and 2015 that created existential problems. The collapse of the eurozone could be averted and progress on stabilizing the euro area was made as well. Some of the countermeasures, however, led to disagreements and fierce criticism. Moreover, it is clear that the adjustments of the Euro’s architecture are insufficient and partially of a provisional nature.

Even though there is a consensus that more reforms have to be implemented to base the Monetary Union on a solid, well-functioning fundament ensuring that future shocks do not bring the whole system to the brink of the abyss, no agreement for a large-scale redesign was found yet. This is due, among other things, to the fact that in the current political and social environment it is rather difficult to find a solution that is both expedient and agreeable. Nonetheless, a way out of the crisis must be found and, in fact, many proposals have been contributed in order to do so. The objective of this thesis is to review the suggested solutions to find answers to the question “how can the euro area crisis be solved in the long run”?

For the purpose of approaching this question, the following structure shall apply: Before dealing with possible solutions, the design flaws of the Currency Union will be identified in part 2. In order to get a greater understanding of the characteristics of monetary unions, the optimum currency area theory (OCA) will be presented first. Thereby, it will be outlined that countries should fulfill several criteria before sharing a currency. Since the eurozone member states did not meet the requirements, additional regulations were established to ensure that the countries would at least eventually develop into being close to an optimum currency area. However, it will become evident that this plan failed in a sense that the member states economically drifted apart even more after the Euro was introduced. In the aftermath of the World Financial Crisis the outcomes of the adverse divergence process became obvious, but then it was too late to avoid the escalation of the euro area crisis. In various sections it will be analyzed why the surging imbalances could be built up and why the handling of the crisis was so difficult for the European decision-makers. In the course of this analysis it will be detected that economists still have different views on the deeper causes of the crisis and mainly disagree on the question whether the lack of fiscal discipline or the member states’ dependency on capital markets behavior was the key driver of the crisis.

In part 3, the countermeasures that have been applied will be listed and grouped in the three categories macroeconomic measures, monetary policy and Banking Union. Afterwards, in a next part, these rescue efforts will be examined more closely to reveal their benefits and possible adverse effects. It will be concluded that the measures were inevitable to prevent the break-up of the eurozone, but that they do not sufficiently remedy the underlying construction faults of the Monetary Union and that some of them should be replaced due to negative implications. This part will be finished with an interim conclusion in which the remaining problems that still need to be tackled will be highlighted.

Part 5 will include a wide selection of proposals that aim at solving one or more of these unresolved design faults. The suggestions will be categorized according to the proposed degree of economic integration. The ones implying further integration steps in the form of an advanced fiscal union or Eurobonds, for instance, will be reviewed first. Thereafter, concepts how to impose more responsibility on the individual governments and to generally eliminate the divergence of control and liability in the euro area will be scrutinized.

Based on the analysis of the crisis origins, the countermeasures, the open issues and the proposed solutions an idea how to reform the Currency Union such that it is finally made viable and more resistant to asymmetric shocks will be developed in part 6. Thereby, a three-part proposal of Corsetti et al. (2016) will be used as reference point. Ultimately, the thesis will be rounded off with a conclusion.

Several limitations have to be made in advance. Some economists and other observers arrive at the insight that it would be the best solution to find an orderly way how to break up the eurozone. There are reasons that justify this argumentation, but in this research paper it is assumed that the continuation of the Euro is the only realistic option. Hence, the disintegration of the Currency Union will not be addressed. Furthermore, it should be stressed that the approach to answering the research question is very comprehensive. Each describing and discussing the roots of the crisis and the counteractions could easily fill a thesis alone. Combining both and adding potential solutions implies that not all details can be illustrated, even though it is intended to cover as many of them as possible.

2 Origins of the euro area crisis

2.1 Theory: Optimum currency areas

The OCA theory explores the costs and benefits of a common currency and establishes criteria that make participating in such a monetary union reasonable. Optimality is defined as the realization of both internal and external balance (Tavlas 2009: 536). There are six criteria that can be divided into three economic and three political points. The first three criteria were contributed by Mundell, McKinnon and Kenen who are considered to be the most important authors from the first, traditional phase of OCA theory (Broz, 2005, p. 59). There was a second phase afterwards with input coming from more authors such as Corden (1972), again Mundell (1973), Ishiyama (1975) and Tower and Willet (1976).

The OCA theory starts from weighing the costs and benefits of sharing a common currency. The advantages of a monetary union are reduction of transaction costs, abolition of currency risk, higher price transparency, enhanced trade and greater competition as prices are easier to compare (Krugman, 2012: 440). By contrast, the main cost arises from the fact that fixed exchange rates or, respectively, a common currency withdraw the exchange rate as an instrument of adjustment from governments (ibid.). This is detrimental in the event of an asymmetric shock or a symmetric shock with asymmetric effects that lowers the export level of a country. In such a case, it would be conventional for a state to react with currency depreciation in order to make its own products cheaper abroad. Due to the fact that this is not possible for members of a currency union, the adjustment process becomes more complicated. In addition, the common central bank carries out a single monetary policy for the whole currency area, which means that it aligns its interest rates to the economic conditions of all member states (Baldwin, Wyplosz 2015: 359). In the event of an asymmetric shock it is likely to set the interest rates according to the average which is neither perfectly suitable for the affected nor the unaffected countries (ibid.).

The state hit by the shock must then restore competitiveness by lowering prices and/or wages (Eichengreen 1990: 143). However, this is a painful process and if prices and wages fail to decline significantly, unemployment results. The amount of the costs depends on the extent of the asymmetric shocks that hit a currency union member state and the ease with which the affected economy is able to adjust (Maes 1992: 147). This ability of adjusting is examined in the OCA theory and depends on the following six criteria.

2.1.1 The six criteria of OCA theory

The first criterion, factor mobility, was contributed by Mundell in 1961 (Ibid.: 138). Mundell (1961: 958-659) discovered that it becomes less cumbersome to deal with asymmetric shocks when the factors of production, capital and labor, can be moved easily across borders. A given factor mobility would enable a country that experiences a negative demand shock and a subsequent increase in unemployment to shift labor and capital to another member state with higher demand and inflationary pressure. The argument seems valid, but three critical points should be mentioned (Baldwin, Wyplosz 2015: 363). Firstly, cultural and linguistic differences complicate the relocation of workers across borders. Secondly, produced goods may differ from country to country; hence it would take some time to retrain the employees until they can start working effectively. Finally, workers need equipment to be productive. Shifting labor from one country to another could fail because of insufficient means of production in the absorbing state. Labor is mobile as well as financial capital, but plants and equipment cannot be easily relocated. Thus, it can be concluded that even if labor was mobile, it could take years to create the necessary framework. By then, the asymmetric shock may be over anyway.

The second criterion was first stated by McKinnon in 1963 and deals with the openness of a country. McKinnon concentrated, unlike Mundell, on the goods markets and on the conditions which make exchange rate adjustments ineffective (Maes 1992: p. 145). He divided economies into tradable and non-tradable goods sectors and linked the openness of a country to its share of tradables (Ishiyama 1975: 349-350). By arguing that domestic currency prices of tradable goods would change to a more or less equal extent when an open economy uses exchange rate adjustments to correct external deficits, he concluded that countries that heavily trade with each other are rather compatible to form a currency union (Broz 2005: 57). Baldwin and Wyplosz (2015: 365), however, object that the trend towards international value chains makes the criterion less relevant as imported components become more expensive when the currency is depreciated.

Six years after McKinnon had published his ideas, Kenen (1969: 65) introduced the third criterion which consists of product diversification and similar production structures. He claimed that a country with a well-diversified production sector will not face strong asymmetric shocks in the first place since there will be export losses and successes, but the aggregated level will be more or less constant. Thus, product diversification would forestall the need for modifications in terms of trade through the exchange rate, thereby making a state more suitable to a currency union (Tavlas 2009: 539). Furthermore, Kenen pointed out that if countries have a similar production structure, a sector-specific shock was likely to affect them equally. Again, this would qualify them for sharing a common currency (ibid.). Yet, it should be noted that the exact level of required diversification is hard to determine (Baldwin, Wyplosz 2015: 364).

It was also Kenen who recognized that if an asymmetric shock hits a currency union, fiscal integration between the member states can mitigate the effects through fiscal transfers (Broz 2005: 59). This view was shared by Mundell who published two new scientific papers in the early 1970s. He (1973: 115) came to the conclusion that “the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been effectively spreads over the future”. This was tantamount to a paradigm shift, since only a decade before he had posited that labor mobility was confined to rather small national or regional domains which is why countries would be well-advised to maintain an independent monetary policy (McKinnon 2015: 451). As it will be discussed later, fiscal transfers between member states of a monetary union are highly controversial since they can provoke moral hazard. Given a subsequent misbehavior of governments, shocks would not be random and transfers would not balance out but have a permanent direction (Baldwin, Wyplosz 2015: p. 366).

The fifth criterion deals with the political dimension and highlights that a high degree of homogeneity is vital within a monetary union (Torres 2008: 63). According to this reasoning, asymmetric shocks would provoke conflicts if the member states’ preferences were too heterogeneous, since countermeasures often require a consensus. An example would be the single monetary policy of a shared central bank. Baldwin and Wyplosz (2015: 366-367) criticize the unspecific character of this statement and advert to the fact that disagreements are normal in politics, even within a country.

The sixth and final criterion refers to the interstate relationships. When the adjustment possibilities, the level of homogeneity of production structures, consumption patterns and openness to trade are insufficient, solidarity may help to keep a monetary union sustainable (Torres 2009: 63). Since none of the criteria is likely to be fully satisfied, asymmetric shocks will always cause political disagreement regarding the correct response. This is a normal feature in any country where solidarity among the citizens contributes to the acceptance of the resulting solution of a debate and the bearing of costs. Occasional costs from asymmetric shocks should be more than compensated by benefits of a common currency. However, if the benefits are too diffuse to be fully observable solidarity becomes essential (Baldwin, Wyplosz 2015: 367). This supports the viewpoint that monetary unions can only emerge after a political union which implies the necessary solidarity among the member states. In any case, the past years have shown that the issue of solidarity can be a very narrow tightrope walk.

After the two waves in the 1960s and 1970s there was a slowdown in research about OCA theory, most probably there were no practical examples of currency unifications (Broz 2005: 61-62). In the 1990s, OCA theory received a new boost as the European Monetary Union (EMU) was to come. Modern OCA theory set new topics on the agenda, such as effectiveness of monetary policy, correlation and variation of shocks and synchronization of business cycles. However, as the new insights play a less important role for the research question of this thesis as well as for reasons of space, the modern views on OCA theory will not be examined.

2.1.2 Did the eurozone fulfill the OCA requirements?

Naturally, the question arises whether the member states of the euro area met the conditions of OCA theory. As pointed out before, countries most likely do not meet the criteria to the full extent and, as a matter of course, theory can never perfectly reflect and predict reality. Nevertheless, in the present context it is helpful to evaluate the countries’ qualification to enter the eurozone according to the OCA benchmarks. Again, due to lack of space, it is not possible to carry out a detailed analysis for each country. However, reviewing literature yields a rather clear outcome in this respect anyway: in the years before and when introducing the Euro, the participating European states were far from forming an optimum currency area (Frankel 2015b: 110).

Fuest and Becker (2017: 109) state that three points were most relevant for the eurozone. First of all, a high level of openness and integration, which was given due to the European Single Market. Secondly, product diversification as well as homogeneity of the production structure was existent or, put differently, at least not worse than in the USA. As third aspect, Fuest and Becker mention adjustment mechanisms which include labor mobility and fiscal transfers. Here, most economists (cf. Stiglitz 2017: 11, Scharpf 2011: 325 or Baldwin, Wyplosz 2015: 370-371) agree that the euro area member states exhibited major defects from the very beginning. Cross-border labor mobility was low, labor markets were rigid and interregional transfers were almost completely missing. Moreover, the countries were very heterogeneous with regard to their economic structures therefore also their growth and inflation dynamics.

Additionally, Baldwin and Wyplosz (2015: 374-375) discuss the remaining criteria and deduce that preferences, for example in terms of inflation rates or public debt, were and are rather heterogeneous. They postulate that this is reducible to the fact that policy-making institutions differ from country to country with respect to the roles of executive and parliament or the influence of trade unions. With reference to solidarity, they infer that it is exceedingly difficult to measure this criterion.

2.2 Design flaws in the EMU

2.2.1 Convergence criteria and further rules

In the previous part, it became evident that the countries that opt for sharing the Euro as common currency did not adequately fulfill the OCA criteria and thus were not really compatible for creating a monetary union. Apart from that, it is worth remarking that not only economists then and now were in agreement about the shortcomings, but also European decision-makers were aware of the deficiencies. The founding fathers of the eurozone knew that the fiscal, financial and monetary institutions were not sufficiently developed for a sustainable currency union in Europe (Corsetti 2015: 85). Yet, the politics was not strong enough to implement powerful institutions that would have been necessary to make the Euro a successful project right from the start (Stiglitz 2017: 11). Consequently, the politicians decided to proceed in gradual phases in order to achieve a convergence of the financial and economic capability of the individual member states (Riehle 2016: 20-21). Additionally, by implementing further rules it should be prevented that the incompleteness of the eurozone’s architecture would have dire effects. However, the European countries could only agree on the lowest common denominator and were left with hoping for the preferences to converge over time such that the required institutions could be created eventually (Bongardt, Torres 2017: 18). One outcome of the negotiations was the establishment of the so-called convergence criteria (or ‘Maastricht criteria’). This set of requirements was arranged to ensure that at the beginning the euro area states would have a minimum convergence level, which they were supposed to increase thereafter by continued adherence[1] (Afxentiou 2000: 249). The countries that intended to join the Monetary Union had to commit to (i) having an inflation rate not above 1.5 percentage points of the average of the three member states with the lowest inflation rates, (ii) having a public budget deficit of not more than three percent of its GDP, (iii) having a gross debt-to-GDP ratio of not more than 60%, (iv) having nominal long-term interest rates not exceeding by more than two percentage points the rate of the three best performing member states in terms of price stability, and (v) participating in the European Exchange Rate Mechanism II without large-scale realignments.

Against the backdrop of building the eurozone on a weak fundament, European leaders decided to set up further regulations. In particular, two articles of the Treaty on the Functioning of the European Union should be mentioned in this context. On the one hand, there is Article 123 which prohibits the monetary financing of sovereigns through the European Central Bank (ECB) and thereby guarantees its independency. On the other hand, Article 125, which is better known as the ‘no-bail-out clause’, was enshrined in the Treaty. Both can be seen as additional pillars of the eurozone’s architecture at that time. Their purpose was to produce fiscal discipline among the member states, to ensure price stability in the euro area and to rule out mutual assumption of debt.

2.2.2 Convergence plan, but divergence reality

As described, the imperfect construction of the Currency Union should be compensated by implementing rules and requirements such that the member states could realize the requisite convergence in the years after the Euro was installed. However, as it will be illustrated in this section, this plan failed monumentally.

In fact, not even at the beginning of the Monetary Union all euro states met the convergence criteria (Riehle 2016: 63-64). Belgium and Italy, for instance, should not have been allowed to enter the eurozone due to their high debt levels. While these rule violations were known, other contenders clandestinely distorted their numbers in order to fulfill the Maastricht criteria (Winkler 2016: 154-155). Greece was also far from being ready for a European currency and from providing satisfactory economic data (Frankel 2015b: 112). As it was revealed later, Greece handed in its application for membership with falsified statistical specifications; inter alia it whitewashed its debt level with the help of Goldman Sachs (Riehle 2016: 64). After this poor start, the eurozone experienced an enormous economic divergence in its first decade, although the opposite was intended. By means of data, this will be shown in the following.

When analyzing the divergence in the euro area between the introduction of the Euro and the start of the crisis, one inevitably comes across differences in competitiveness. A glance at the corresponding literature, however, leads to the conclusion that the economic competitiveness of a country is a broad concept that is interpreted very differently[2]. In order to provide a robust theoretical and empirical link between drivers of competitiveness and macroeconomic performance, the ECB founded the Competitiveness Research Network (CompNet) in 2012. The network sets a main focus on the micro dimension on the grounds that aggregate performance depends strongly on firm-level decisions (Lopez-Garcia et al. 2014: 4). For the purpose of fostering the debate on competitiveness issues the researchers developed a new database with information on the distribution of labor productivity or unit labor costs for individual industries but also at sector-level or considering the full economy. Their analysis includes a wide-ranging list of indicators such as labor productivity, capital intensity, price-cost margin, equity ratios or firm’s total export (Lopez-Garcia, di Mauro 2015: 23). Such an in-depth assessment cannot be given in this thesis, but nonetheless the general conclusion that the competitiveness levels diverged significantly in the first decade of the eurozone, a result at which the CompNet arrives as well (Lopez-Garcia et al. 2014: 5), should be substantiated with a selection of data. In the economic discussion, some factors considered essential for the buildup of large intra-eurozone imbalances appear very frequently. That particularly applies to the price and cost competitiveness[3] and thereby includes unit labor costs.

Graph 1 shows the development of the nominal unit labor costs for a selection of eurozone countries that includes both the crisis-ridden states (mainly in the South of Europe) and some of the more stable states of the North. Evidently, the nominal unit labor costs in Greece, Ireland, Portugal, Spain, Italy and Cyprus (the so-called ‘GIPSIC’ countries) increased tremendously relative to Germany.

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Graph 1: Nominal Unit Labor Costs (1999=100; per person; total economy)

Source: Eurostat, own calculations

However, unit labor costs should be handled with caution. Firstly, former empirical research showed that there is a negative correlation between growth in unit labor costs and output growth (Felipe, Kumar 2011: 3-4). Furthermore, the calculation of unit labor costs can lead to biased findings and arguments can be found that it is not expedient too compare the unit labor costs of the GIPSIC states with those of Germany (ibid.: 5-10).

Bourgeot (2013: 2) agrees with linking common imbalances to divergences in unit labor costs, but objects to the dominant crisis narrative[4] which postulates that the crisis-stricken countries had lived beyond their means or, put more precisely, had experienced a wage drift that had caused their deficits. He (2013: 6-7) claims that looking at nominal unit labor costs is not sufficient to understand the underlying fundamentals of the surge in imbalances. Instead it would be of paramount importance to make a distinction between the different variables that influence nominal unit labor costs and, in particular, to isolate the direct contribution made by inflation.

As illustrated in graph 2, the real unit labor costs indeed deviate from their nominal counterpart. Especially the numbers for Ireland, Spain and Portugal are different. This indicates that differences in inflation played a substantial role during this time period. As a consequence, Bourgeot (2013: 9-11) scrutinizes the member states individually and concludes that low productivity gains and the differing inflations rates were mostly responsible for the divergence in unit labor costs.

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Graph 2: Real Unit Labor Costs (1999=100; per person; total economy)

Source: Ameco, own calculations

Baldwin and Wyplosz (2015: 412-413) also emphasize that permanently higher inflation rates in the peripheral Euro states relative to the core countries[5] promoted the surge of imbalances as their real effective exchange rates (REERs) appreciated accordingly

In this context, it is reasonable to look at the GDP deflator and not the consumer price index (CPI) to check for the inflation differences as the GDP deflator represents the inflation of production and not consumer prices, therefore excluding imports (Bourgeot 2013: 8). In graph 3 it can be seen that Germany was considerably below euro area average in the years before the crisis, while the GIPSIC countries experienced inflations rates above the average[6].

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Graph 3: Average inflation rates (GDP deflator), 2000-2008

Source: IMF International Financial Statistics, own calculations

The data on real labor productivity, documented in graph 4, confirms Bourgeot’s view that rather inflation rate differences and low productivity gains have been the driving force for competitiveness divergence.

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Graph 4: Real Labor Productivity (per person, 1999=100)

Source: Eurostat, own calculations

In regards to Germany, Meloni (2016: 18-19) points out that the exceptional export performance of the German economy was mainly due to the massive wage reduction, but not because of productivity gains. In fact, the productivity development in Germany was rather modest between 1999 and 2009. Meloni continues that, given the restrictive wage policy, especially the manufacturing sector experienced a real devaluation and resulted in a strong decrease in the REER for Germany, while in Southern countries price competitiveness indicators (based on nominal unit wage cost) surged.

Divergences in competitiveness can possibly also be explained by differences in spending in Research and Development, as displayed in graph 5. Naturally, raising funds does not necessarily lead to successful research outcomes and technological innovation. Furthermore, investments in R&D influence the competitiveness only in the medium-to-long term. However, even when pre-euro area years are included it becomes evident that the crisis-ridden states constantly invested less into R&D than the stable countries. This may have contributed to the divergence in competitiveness.

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Graph 5: Total R&D expenditure (in % of GDP)

Source: Eurostat

To summarize, it can be difficult to draw conclusions from competitiveness indicators, but in the case of the euro area it seems unambiguous that a divergence of the member states’ competitiveness has happened (Feld et al. 2015: 191). Differing trends could also be observed in other areas, as it can be seen in graph 6 which contains the current account balance in percent of GDP of the same selection of countries. It is obvious that Portugal, Greece or Spain had negative numbers already before the introduction of the Euro, but after 1999 or, respectively, 2001 there is a further divergence observable. Apparently, the Northern eurozone countries were net lenders to foreigners while just the opposite was true for the Southern states. Baldwin et al. (2015: 5) identify differences in savings and investments as key driver behind this process[7].

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Graph 6: Current Account Balance (in % of GDP)

Source: IMF, WEO database

The combination of eroding competitiveness and negative current account balance developments is likely to result in a large accumulation of debt. Graph 7 illustrates that the euro area countries experienced increasing debt-to-GDP ratios after 2007 which can be related to the World Financial Crisis. Prior to that, the data does not reflect the core-vs.-periphery-structure of the previous categories. Greece and Italy had debt levels far above the 60% debt-to-GDP threshold of the Maastricht Treaty, but this was already the case before the eurozone was brought to life. Particularly worthy of emphasis is that Spain and Ireland, which had to struggle extraordinarily hard during the euro area crisis, were the poster children in the run-up to the crisis with respect to their debt levels.

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Graph 7: Consolidated Gross National Debt (in % of GDP)

Source: Eurostat

It is also remarkable that Germany, Austria and France, hence less crisis-affected member states, had levels above the allowed threshold and thereby continuously violated this Maastricht criterion. Same holds true for the public budget deficit. Graph 8 indicates that, while Ireland and Spain met their obligations, Greece was constantly far from doing so and that Italy, Portugal, France, Germany, Austria and Cyprus were more than once beyond the 3% limit.

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Graph 8: Annual government deficit (in % of GDP)

Source: Eurostat

In summary, it can be said that the plan of the eurozone’s architects did not work. Instead of economic convergence, the member states diverged significantly in terms of competitiveness which caused the accumulation of imbalances. The direction of these developments is the same in most cases: the Northern euro area countries experienced competitiveness gains relative to the Southern euro area states and built up current account surpluses while the South run into trade deficits. With regard to the debt and deficit levels, however, the structure is not that clear. Evidently, also stable eurozone sovereigns violated the Maastricht criteria, while both Spain and Ireland which faced huge difficulties during the crisis complied with the rules.

Before starting with the next section, a convergence that actually happened should be mentioned. The interest rates on sovereign bonds with a ten years maturity markedly converged shortly prior to the introduction of the Euro and followed similar movement patterns thereafter. This becomes apparent in graph 9. Consequently, the borrowing costs were significantly lowered, both for private and sovereign borrowers (Baldwin et al. 2015: 3)[8]. Drops in refinancing costs were particularly large in Italy, Portugal, Spain and Greece. The Italian government, for instance, had to pay an interest rate of 12.21% in 1995 and only 4.73% four years later.

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Graph 9: Ten-year government bond rates

Source: OECD database

2.2.3 How was the divergence possible?

In the last section, it was explained that the planned convergence in the eurozone did not happen, but that the member states economically moved apart from each other instead. Naturally, this begs the question how this development could emerge. However, before examining the reasons for the divergence, two limitations have to be made. First of all, the economic development of a country depends not only on the framework of the currency it uses, but on various micro- and macroeconomic factors and decisions made by politicians, private households, companies, capital market participants, and so on. Since a detailed, country-specific analysis cannot be given here, the focus is put on design flaws at eurozone level and less on national conditions.

Secondly, when attempting to find answers to the question why the member states diverged, one starts delving into the causes for the euro area crisis. As a matter of fact, there are rather proximate and rather deep causes. Especially with regard to the deeper, underlying roots of the crisis, economists are still divided by disagreement and each scientific contribution claims prerogative of interpretation of the facts and data. It is in the nature of things that the results of a root cause analysis essentially influence the ensuing solution finding. However, there is neither a consensus on how to interpret the divergences and imbalances nor on the underlying causes. Accordingly, as it will be pointed out later, opinions on how to stabilize the euro area are (therefore) deeply divided as well[9].

False start: false theory, false initial conversion rates

Looking backwards, the decision to implement the Euro on such a weak fundament nearly seems surprising today. Therefore, in order to understand the background of the eurozone’s construction, one needs to be aware of the fact that the creation of the Euro was a political decision in the first place. European political decision-makers knew about the shortcomings (see above) and were warned by several economists[10]. However, they decided to accomplish the Currency Union in an early, imperfect stage. Prior to that, two conflicting theoretical approaches had been discussed. One side argued that the Euro should be the last step of European integration and be based on a political union which should be established first (Fuest, Becker 2017: 29). This view, also known as “coronation theory”, was mainly shared by the former German Chancellor Helmut Kohl and the German Central Bank. The opposing side, by contrast, found that the Euro should sooner rather than later be introduced and form the beginning of an evolving European integration with the objective of building a political union. Supporters of this viewpoint assumed that shocks would hit the eurozone and disclose the shortages, but expected the conflicts to be manageable due to the historical importance of the Monetary Union (Corsetti 2015: 86). This opinion is reflected in a statement of Jean Monnet who once wrote that "Europe will be forged in crises, and will be the sum of the solutions adopted for those crises" (Barroso 2011). Another argument was that currency unions tend to increase trade among its members and thereby raise the symmetry of shocks. Hence, a monetary union may develop into meeting OCA criteria ex post even if it does not ex ante (Frankel 2015b: 111).

Clearly, the latter vision prevailed and the Euro was created in the absence of a political union. Fuest and Becker (2017: 29) indicate that the French side put pressure on Germany since the strong German Central Bank was annoying for France as its leading status in the European financial system restricted the French monetary policy. The German government conceded as the Kohl era was nearing its end and the opposition was more and more skeptical about the Euro. The German political leaders did not want to miss on the historical opportunity to foster the European integration and also to win the French government over for the German reunification (ibid.: 32). Nonetheless, political preferences differed and hence the individual objectives: while Germany, Austria, Netherlands and Finland sought for low inflation rates, France and Italy expected economic-stimulating policies from the ECB (ibid.: 36). For this reason, France insisted on Italy, Spain and Portugal to be founding members of the Monetary Union in order to shift the political equilibrium of the eurozone towards France (Riehle 2016: 63-64). Moreover, taking Belgium, which clearly did not fulfill the requirements, in the Currency Union was purely politically motivated as there was a consensus that they could not be left out as founding members of the European Economic Community (ibid.).

Maybe it was just bad luck that the first crisis was of such a large extent as the Great Recession in 2009 (Corsetti: 2015: 86). Possibly, a smaller crisis with less negative impacts had brought the eurozone on the right track. From a today’s perspective, however, it appears obvious to conclude that it would have been the better choice to postpone the implementation of the euro area and to improve conditions first. At least, starting the euro area with twelve member states seems to be a wrong decision which caused that Monnet’s rationale was eventually turned on its head.

The divergence was also promoted by economic misjudgments: when exchanging the national currencies for the Euros, the initial conversion rates were miscalculated (Baldwin, Wyplosz 2015: 413). For instance, the German conversion rate was too high, while the Greek one was undervalued (Scharpf 2011: 327). Consequently, this contributed to the diverging competitiveness.

Ineffective (public) Debt control and macroeconomic supervision

So evidently, by ignoring economic principles, politicians based the eurozone on false assumptions. Yet, as mentioned before, the politicians realized that the start of the Euro was ill-fated and therefore wrote down strict rules in the Maastricht Treaty. Accordingly, it must be asked why there was a lack of corrections of the undesirable developments over time. The simple answer to this question is that the agreements were breached without entailing serious consequence for the rule breakers, but naturally it is reasonable to look more precisely at this issue.


[1] The convergence criteria were integrated into the Stability and Growth Pact (SGP) which was created in 1997 to enhance the monitoring and coordination of the member states’ fiscal and economic policies to enforce the deficit and debt thresholds established by the Maastricht Treaty.

[2] Porter (1991: 93–97), for example, starts from the basic principle that the competition is between companies, not countries. In his so-called Diamond approach, he points out that both business-strategic concepts and economic conditions are crucial factors for competitiveness. Lawrence (2002) focuses on the general living standard and uses macroeconomic values such as output per worker or income per capita. For Krugman (1994: 37), however, data about total factor productivity is of crucial importance in this context. Schwab and Sala-i-Martin (2014: 4) “[…] define competitiveness as the set of institutions, policies, and factors that determine the level of productivity of a country” and provide a twelve-part list of pillars of competitiveness which, among others, includes infrastructure, goods and labor markets efficiency and financial market development. They (2014: 8) point out that notably (technological) innovation is essential for long-run productivity growth and a resulting sufficient competitiveness level. Therefore, they consider investment in research and development (R&D) to be an indispensable requirement.

[3] The ECB calculates Harmonized Competitiveness Indicators (HCIs) in order to evaluate the price or cost competitiveness of the member states relative to their principal competitors (both intra and extra euro area). In this context, they also make use of the GDP deflator and unit labor costs for the total economy which both will be examined in the following.

[4] In Baldwin et al. (2015: 1), for example, declining levels of competitiveness are traced backed to increased public spending which in turn raised the wage level as well as the costs of the respective countries. Riehle (2016: 61) refers to high wage increases in the GIPSIC states as cause for their weak price competitiveness.

[5] In both the literature and the media it is frequently distinguished between peripheral and core countries of the euro area. However, there is no official definition of these terms. The eurozone periphery is mostly equated with the GIPSIC countries, while the core includes Germany, France, the Benelux countries, Finland and Austria. This understanding shall apply for this thesis.

[6] In fact, all four state that eventually signed bailout packages, namely Greece, Ireland, Portugal and Spain (see below), had inflation in excess of the average.

[7] Baldwin et al. provide further data on savings and investments which shows that the GIPSIC countries had below-average savings and tended to overinvest at home. Conversely, core nations such as Germany, the Netherlands, France and Belgium saved above average and tended to underinvest domestically.

[8] Baldwin et al. point to the fact that interest rates not only fell in European countries, but also in other advanced economies such as the USA, the UK and Japan. However, they still relate the drop of borrowing costs in Europe to the capital markets’ anticipation of the Monetary Union.

[9] It should be noted that, in a broader sense, two opposing views exist whose advocates disagree on the causes and, by implication, on the expediency of the countermeasures that were carried out so far as well as on how to stabilize the euro area. In the course of this thesis, it will be clarified which arguments are urged by both sides with respect to these subject areas.

[10] In 1992, a group of 60 economists teamed up and formulated a declaration in which they argued that the introduction of the Euro was premature and would lead to severe economic problems. In fact, the euro area experienced serious difficulties; however, in a different way than it was forecasted (Plickert 2017).


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Johannes Gutenberg University Mainz
monetary union currency crisis euro reforms History of the euro




Title: How can the euro area crisis be solved in the long run?