Crisis Cycle
Challenges, Evolution, and Future of the Euro
Crisis Cycle: Challenges, Evolution, and Future of the Euro, with Luis Garicano and Klaus Masuch will be officially released June 17 2025. For only $35! My webpage will have reviews and updates.
Here is a summary and overview:
A common currency is a wise and necessary component of European integration and economic vitality. The euro was set up presciently. But its evolution in a sequence of crises now leaves the euro in a vulnerable state. It needs fundamental reforms to survive and prosper. Our book “Crisis Cycle: Challenges, Evolution, and Future of the Euro” tells this story and recommends reforms.
A monetary union without fiscal union leads to an obvious temptation: Member states might borrow and spend more than they can repay, and then call on the central bank for a bailout using newly printed money. The architects of the euro understood this danger well. They designed an independent European Central Bank, whose mandate is exclusively price stability. The ECB did not buy sovereign debt. Countries would follow debt and deficit limits. The countries of the union also committed against fiscal bailouts.
But the founders left a few bits unfinished. In a currency union without fiscal union, overindebted countries must, in extreme circumstances, default just as companies do. The euro founders couldn’t quite say this. They made no provision for sovereign default, and no crisis mechanisms to help sovereigns stave off default. Banks were and continue to be allowed to treat sovereign debt as risk-free, encouraging its holding but meaning that sovereign default imperils banks.
This is understandable. Nobody in the 1990s foresaw advanced-country sovereign debt problems or a financial crisis. One does not write every contingency in a founding document, or negotiate a prenuptual agreement too harshly the day before the wedding. One naturally expects that a founding document will evolve and be elaborated over time. It is that continuing reform which has stagnated.
Already in the early 2000s, France and Germany breached the debt and deficit limits, without repercussion. In the financial crisis, the ECB began to lend much more freely to banks, against riskier collateral including sovereign debt, and thereby encouraging banks to buy. The ECB began, unintentionally, to finance a large share of balance of payments deficits via Target2 balances. Countries paid for imported goods with debts to the ECB.
The 2010 Sovereign Debt Crisis was the earthquake. The ECB, feeling it was the only game in town, intervened on a large scale, including large sovereign bond purchases, lending to banks that funded banks’ sovereign bond purchases, and Mario Draghi’s famous “whatever it takes.” Eventually, an adjustment program mechanism emerged, allowing support with conditionality and imposing some losses on some creditors. But this institutional reform later fell from grace, and has been crowded out by other ECB interventions starting in the early 2020s. Self-imposed rules on bond purchases weakened with each new programme.
Bond buying in the quantitative easing (QE) era further enlarged the ECB’s sovereign bond holdings, and surged during and after the Covid-19 pandemic. The ECB introduced “flexibility” in purchases to keep sovereign spreads from rising. The bout of inflation, reaching 10%, while the ECB continued bond purchases and kept rates low, undermined confidence that the ECB can and will control inflation, making any future crisis more unstable.
So here we are. Europe is in a fragile state. Overregulation and bureaucracy stifles innovation and growth. European member states’ debts have risen dramatically. The ECB holds large portfolios of sovereign bonds, and is widely expected to buy more anytime yields or spreads threaten to rise. Banks remain stuffed with sovereign debt, so any sovereign crisis becomes a bank crisis. The next crisis will challenge European sovereign debts. That crisis may be bigger than even the ECB can handle without chaotic defaults, financial meltdown, or sharp inflation.
Most of all, Europe is suffused with moral hazard. The incentives for governments to tax and spend wisely, reduce debts, and reform is much reduced. The incentives for investors to evaluate and monitor sovereign risks, and to shift them out of highly leveraged banks is reduced.
The problem does not lie in the ECB’s expedients in crises. The problem lies in the failure of member states and European institutions to reform after each crisis so the ECB does not feel the need to jump in once again.
We outline a program of reforms. Summarizing, there must be a European fiscal institution that can quickly offer support, subject to conditionality, to help member states in trouble, allowing the ECB to avoid that inherently political and fiscal task. But the eventuality of default must remain a possibility. Banks and their regulators must treat sovereign debt as risky, and must hold less of that debt, and more diversified portfolios. Sovereign debt must be in hands that can bear risk. Completion of European banking union is an important step to that goal. The ECB must reduce its sovereign bond portfolio, its lending against weak collateral, and its aversion to letting any sovereign spread rise.
Europe needs growth. One prerequisite is a common currency, a central bank, a banking system and a financial system that do not incentivize fragility and can withstand the next shock, as the founders envisioned.
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Three nice quotes in the frontispiece summarize a lot of the story.
“Because it is France.”
Jean-Claude Juncker, president of the European Commission, on France (and Germany) ignoring debt and deficit rules.
“Whatever it takes.”
Mario Draghi, President of the ECB, on ECB buying sovereign debt to forestall Greek exit
“We are not here to close spreads”
Christine Lagarde, President of the ECB, on buying bonds to lower Italian bond yields. (When spreads immediately jumped up, she quickly amended her statement, and the ECB has been closing spreads ever since.)
This seems surprisingly boilerplate consensus, coming from you.
A history of--and reform options for--the euro would best start by acknowledging that it was the result of extreme/hubristic policy ambition (especially in France), coupled with technocrats' misunderstanding of the overall macro environment.
First, Mitterand needed something to acquiesce to German unification, and the prospect of unshackling the hapless French franc from the DM was too precious to resist.
Second, technocrats were well aware that fiscal dominance could undermine the future currency's stability and designed a rigorous set of fiscal convergence criteria that needed to be met before countries could participate. However, the same technocrats completely missed the elephant in the room--the fact that German unification led to massive consumption-smoothing fiscal transfers from West to East Germany and resultant much higher-than-historical deficits. Thus, it was Germany doing the fiscal conversion downwards, rather than other countries sustainably improving. Moreover, the large excess demand in Germany spilled over into other EMU countries' much better external positions. Thus, when 1999 came, the EMU looked fiscally and externally quite similar, but that was not a sustainable equilibrium.
Third, technocrats did not foresee that this rebalancing left Germany--in the Economist's term--as the "sick man of Europe" and that German voters would vote for economic reform. That reform turned out to be the German-favorite "competitiveness improvement", i.e., wage moderation, cost cutting, and resultant internal devaluation. Thus, German current account surpluses surged again.
Fourth, the ECB and other technocrats missed the significance that access to German interest rates with large German competitiveness gains would result in excessive current account deficits in much of the other euro area countries. I can't recall the number of times in the early 2000s I was lectured by some European central banker or other that current account deficits did not matter within a currency union, safe in the knowledge that Target 2 would grow forever, or some kind of rebalancing miracle would arrive in due course (btw, this is not unsimilar to many US central bankers' contemporaneous view that there would never be a nationwide housing crunch...).
Fifth, when the fan was hit, politicians (especially Merkel and Sarkozy) sought glory by insisting that--of course, theoretically correct--default was an alternative to bailouts, without again realizing the internal dislocations that would bring. They thus shifted the political bailout responsibility onto an ECB leadership that had little choice but to go along (which central bank wants to blow up its own currency?).
Sixth, the ECB made valiant technocratic efforts to demand conditionality, but again, never had the apolitical backbone to see them through. OMT, announced to great fanfare in 2012, was never used. The most likely reason is that it required an IMF program, and even an in-the-doldrums Italy could not be convinced, and the ECB much rather bought more government debt (via Bank of Italy). A not-too-dumb move given that it propelled Draghi to the Premiership in Italy.
With that history, I am quite skeptical, that proposals like your joint fiscalization "with strong conditionality" would achieve anything more than what we have seen in history. No doubt, any number of smart schemes will be created, but once it starts to matter, more politically expedient or economically realistic steps will be taken.
In the final analysis, the euro could have become a bigger DM (and Europe a more dynamic, less government-dependent economy) if greater care had been taken in the 1990s to ensure sustainable rather than headline point-in-time convergence. Early steps in the 2000s to limit Target2 were likely the final chance to correct the course, but that is long past.
Now we are left with a currency that resembles the FFR and Lira more than the DM. That may be good for the global economy, but no amount of institutional tinkering will make it a currency backed by strong government finances.
The founders of the Euro were fools to think politicians would stick to balanced budgets. Politicians always spend more than they get in from taxes. The average person knows this but as the founders of the Euro were part of the Establishment then they were not going to lock in politicians to balanced budgets. So debt will continue to climb, more of the budget will go to servicing the debt and services the public expect will incrementally decline year after year