Can the Euro Survive?


Just before the single currency turned 20 years of age, having been introduced on January 1st 1999, the Italian Prime Minister in a conciliatory move towards the European Commission has offered to lower the national deficit to 2.04% for 2019 after a period of tense negotiations with Brussels. Some have argued that this was an inevitable move, while others were perplexed that the populist government had given in.

As the standoff between Italy and the Commission has momentarily come to a close, and given that a recent article on the Economist has sparked debate about the faith of the Euro, it seem appropriate to reflect on broader issues liked to the single currency, and in particular to ponder which ones were the most important structural issues that led to the eruption of the Eurozone crisis, what steps have been taken to fix them and what are the prospects for the future of the single currency.

I will break down the political economic problems that the Euro area has faced in three categories, related to sovereign debt, financial markets and economic divergence. Such a distinction, particularly for the first two sets of problems, results artificial, but it comes useful for the purpose of this analysis. I will argue that only some of those issues have been addressed.

Through the course of this article it will become manifest that the recipe for a way forward based on further integration has already been written, but contingent political circumstances make it unlikely that a formula based on “ever closer integration” will be applied. Alternative solutions need to be explored.

Sovereign Debt

Political and Economic problems

Following the Greek revelations of its under reported dept in late 2009, fiscal issues made it to the forefront of policy maker’s attention within the Eurozone. What became manifest were the high level of debts accumulated in some southern countries, in particular Greece, where public debt was the issue, and Spain, Italy and Portugal, where private debt was the main concern. In turn, this exacerbated the problems for big national banks that were coping with the ripple effect of the US banking crisis. Indeed, within the European Union national banks were buying great amounts of national bonds, without diversifying their risk across borders. This resulted “from both policy principles and the inherited structures of national financial systems. Whereas the euro area is integrated monetarily, banking systems are still largely national.”[1] In fact, as Pisani-Ferry has argued, “the exposure of governments to ‘their’ banks and of banks to ‘their’ governments makes public finances in the euro area particularly prone to liquidity and solvency crises.” This is important when keeping in mind that unlike the US, the Eurozone is very much vulnerable to solvency crises.

Immediately, political issues started to manifest themselves. In fact, one of key tenets of the Euro is Article 125 of the TFEU. The article introduces a no-bailout clause, otherwise known as “no co-responsibility for public debt”. It stipulates that “governments in the euro area are individually responsible for the debt they have issued”. Such principle was introduced to prevent national moral hazard, implying that the risk of default of a sovereign was one to consider. However, international markets did not believe that Berlin was going to allow a member of the single currency to default on its debt. Indeed, since 1995 in anticipation of the single currency government bond yields for all prospective Eurozone members started converging to the German rate.

Additionally, there were credibility issues associated with the set of EU rules designed to guarantee sound public finances, the Stability and Growth Pact (SGP). Its two basic principles stipulate that a government should not run a deficit that exceeds 3%, and that a country’s Debt-to-GDP ratio should be under 60% or on a satisfactory downward trajectory. Not only France and Germany were the first to breach the 3% rule in 2003, but the 60% value is simply arbitrary, as there is no clear economic reasoning behind it. A widely cited report by Reinhart, Rogoff and Savastano confirms this claim. They point out that many middle-income countries have defaulted with a debt to GDP ratio below 60%. Additionally, they show that in some cases the “safe” ratio is as low as 15%, albeit for emerging market economies. Even admitting that such a threshold is reasonable for European countries, the IMF has estimated in 2011 that the “required primary surplus [needed to reach this level by 2030] is well above levels they [countries in breach] have sustained in the past”.

Measures and solutions

The credibility of the SGP and the high levels of debt are manifestly interlinked problems. In fact, when the Greek crisis broke out, harsh austerity measured were imposed by northern states onto their southern partners, while the envisioned long-term solution was the introduction of tighter fiscal rules and automatic supervision mechanisms. A series of concrete reforms were introduced in this direction, namely the “Sixpack”, the “Twopack” and the European Fiscal Compact, as well as the European Semester. These legislative measures aimed at strengthening the SGP, introducing greater macroeconomic surveillance and enhancing the EU’s role as advisor and coordinator in terms of national economic policies. The impasse that took place in late 2018 between Italy and the Commission resulted precisely from the adoption of these rules.

The other set of interconnected problems is made up of the “no bailout close” and the bank-Sovereign interdependence. On a theoretical level, what is needed is a reform of the treaties to address issues concerning the “no co-responsibility for public debt” provision and the introduction of regulations to limit bank/state exposure to a single lender/borrower. To work around the first problem, the European Stability Mechanism (ESM) was introduced, with a lending capacity of €500 Billion and the explicit goal of tackling new bailouts. However, the second problem has proved to be a harder nut to crack. In fact, as Germany proposed to limit the amount of national debt held by national banks, Spain and Italy bitterly opposed it as it would have caused massive disruptions to their economies. In response, new rules regarding bail-ins were introduced, which mandated that shareholders take an initial hit when saving a bank. However, this provision coupled with raising inflation since mid-2016 led to the sell-off of large chunks of bonds by investors. In other words, heterogony of ends had made its course.


Financial markets

Political and Economic problems

Closely linked to fiscal trouble, and often a significant cause, was the role of financial markets at the beginning of the crisis. Two mechanism operated in parallel. In fact, speculative attacks (rapid sell-offs of bonds) have caused a vicious cycle of fast rising interest rates in already critical circumstances. Mostly periphery states, such as Greece and Italy were affected. At the market level, contagion from the US subprime crisis pushed many European banks which held such assets into crisis. As the states bailed out the banks, this turned into a sovereign debt crisis (particularly in Ireland). Related stands the political issue of the ECB mandate. In fact, according to the treaties the ECB is not a lender of last resort, as unlike the FED it’s mandate is not to “to support financial stability and growth”, but simply to keep “price stability”, which is interpreted as maintaining inflation at just under 2%.

Measures and Solutions

Theoretically, the way forward to address these problems, and the related fiscal ones, is the establishment of the ECB as lender of last resort, the creation of a full banking union with a common regulatory body and the establishment of a fiscal union with attached Eurobonds (which will be discussed towards the end of this article).

Arguably, the ESM, because of its limited size, “will never have the necessary credibility to stop the forces of contagion [and] it cannot guarantee that the cash will always be available to pay out sovereign bondholders”.[2] At the same time, the ECB already acted as a de facto lender of last resort when it initiated its Quantitative Easing (QE) program as the Eurozone was nearing deflation. If, however, its mandate had been broader, the expansionary policy could have started earlier, and a lot of suffering potentially avoided. Still, there are significant obstacles in this direction. Not only, such a mandate amendment would require unanimity in the Council, but if the ECB incurs in losses on its portfolio, it would require injections from the better off members of the union, de facto enacting a redistributive policy.

When it comes to the banking union, it has to be said that significant progress forward has been made since the acknowledgment of the disastrous effects that speculative attacks had had on the bank-Sovereign “doom loops”. However, such a Union lacks backstops for optimal functioning. At this stage, the Union consists of a Single Supervisory Mechanism, a Single Resolution Mechanism and a Single Rulebook. In short, responsibility for supervision and rescuing of large banks has been moved to the European level, which should minimize the risk of speculation. However, three key elements are missing: a common deposit insurance, common resources for bank recapitalization and system of regulation for bank sovereign exposure. Surprisingly (or not?) opposition comes from both Germany and its highly indebted partners. The first doesn’t want to lose the competitive advantage banks in Germany enjoy with the existing deposit insurance schemes, and the latter are unwilling to give up the stabilizing roles played by national banks, even considering the structural risks for the Eurozone this entails. Naturally, this leads us to the discussion of the ultimate solution, the question of a common budget for the Eurozone[3], which will be discussed in the following section.

Economic divergence

Political and economic problems

Lastly, comes the most fundamental economic issue of the Eurozone, the divergence of Europe’s North and South. Divergence in competitiveness first, which results in divergence in lending and borrowing. Furthermore, the problem stems from the original sin, the fact that the Eurozone was not an Optimal Currency Area (OCA)[4] when it was created, and that the theories regarding the endogenous effects of the OCAs did not fully stand the proof of time. Indeed, the Eurozone was more of a political rather than economic project. As Sadeh and Verdun have written, it can be argued that firstly, in 1978-81, the creation of the European Monetary System was triggered by transatlantic tensions, and that the Economic and Monetary Union was motivated by a Franco-German deal and established against the backdrop of the Belin wall destruction and the subsequent will to tie Germany into the Western camp.[5]

The above-mentioned original sin stems from the fact that Eurozone members’ economies operate in different ways. In particular, Northern economies, generally speaking, are coordinated market economies[6], that have managed to stay more competitive vis-à-vis their Southern partners, in particular due to their wage setting mechanisms, and their export drive has resulted in current account imbalances within the Eurozone.[7] As Johnston has argued, “as long as some member states possess domestic institutions that grant them a comparative advantage in producing low inflation, they will, de facto, have a persistent competitive advantage in the real exchange rate that is conducive toward the accumulation of current account surpluses.” Capital accumulation in the North has resulted in the financing of Southern deficits. It is true that since the Euro crisis erupted, trade imbalanced within the Eurozone have been reduced, but it did not follow systemic reforms, it rather resulted as a positive by-product of austerity programmes.


Measures and Solutions

Given the, to some extent cultural, embeddedness in a society of a variety of capitalism, and the resulting disparity in competitiveness, no economic reform can solve the issue. Theoretically periodical austerity in deficit states can address the problem, but this is not a politically acceptable solution.

An important reform, which can be undertaken to tighten the fiscal framework and help sync the business cycles of the Euro states, is the creation of a fiscal union with attached Eurobonds. Steps in this direction have already been taken, but most control of fiscal policy remains at the national level and there is not much risk-sharing among members of the single currency. A basic form of risk-sharing could be the introduction of a European unemployment insurance system. A more advanced approach would be the creation of Eurobonds, securities jointly underwritten by all member states which would create a safer set of assets and guarantee low borrowing rates for all member states while avoiding speculative attacks on individual ones. However, they can be realistically implemented only if further progress is made in implementing sounder fiscal regulation and scrutiny (i.e. fiscal union).

On paper, this sounds reasonable and making economic sense, but the elephant in the room is the populist spectre haunting Europe. With nationalism on the rise, and a fiscal union being an intrinsically federalist policy which prescribes the surrender of national sovereignty in the tax realm, these steps seem unrealistic. Specifically, Eurobonds would require and imply ex-ante approval of budgets by the commission, which is a huge step in political integration, and additionally, benefits would be unevenly distributed, with, for example, Germany’s borrowing costs likely to rise.


Arguably, good progress has been made in fiscal and financial terms to address the issues that had become manifest following the Eurozone crisis. The credibility of the SGP has been reinforced by the approval of measures like the Sixpack, the Twopack and the European Fiscal Compact. Stricter macro prudential regulation has been introduced, and the European commission plays a stronger role in vetting national budgets. However, the commitment among European governments to such rules cannot be given for granted. A worrisome example came from the Europhile Macron himself. In response to weeks of protest by the “Yellow vests”, his government has made a series of spending promises, concerning pensions and minimum wages, which have the potential to undermine the targets set by the SGP and put Paris on a collision course with Brussels.

Unfortunately, the most fundamental issue underlying an array of Eurozone problems has not been tackled. The export drive of coordinated market economies can be hardly addressed by any economic reform, as specific modes of production are embedded in society, and to some degree constitute cultural habits that are extremely tough to change. At the most basic level, forcing a German to become less competitive to help an Italian get out a crisis (which according to the German he got into himself) is a tough sell. An economically feasible solution could be periodic austerity and deleveraging in Southern states, but the social repercussions and subsequent political outcomes are untenable. Therefore, if something is to be done with the aim of strengthening the single currency and addressing the divergence issue, it has to follow a multi-vector approach. The three fundamental reforms, which entail a huge step in integration, would be the broadening of the ECB’s mandate, the full establishment of a banking union and at last the creation of a fiscal union with attached Eurobonds. However, considering that the drivers of the European project are more political than economic, and given the current populist mood in Europe, developments in this direction following the outlined path seem more arduous than ever.

The key test in this direction will come in May 2019, when elections for the European Parliament take place.

Key sources:


[1] Pisani-Ferry, Jean (2012). The Euro crisis and the new impossible trinity, Bruegel Policy Contribution, No. 2012/01, Bruegel, Brussels.

[2] De Grauwe, P. (2011). The European Central Bank as a lender of last resort. CEPR.

[3] Baldwin, R. and Giavazzi, F. (2015). The Eurozone crisis: A Consensus View of the Causes and a Few Possible Remedies. CEPR Press.

[4] Mundell, R. (1961). A Theory of Optimum Currency Areas. American Economic Association, 51(4), pp.657-665.

[5] Sadeh, T. and Verdun, A. (2009). Explaining Europe’s Monetary Union: A Survey of the Literature. International Studies Review, 11(2), pp.277-301.

[6] Hall, P. and Soskice, D. (2004). Varieties of capitalism. Oxford [England]: Oxford University Press.

[7]  Johnston, A. and Regan, A. (2015). European Monetary Integration and the Incompatibility of National Varieties of Capitalism. JCMS: Journal of Common Market Studies, 54(2), p.320.