The Euro and the Crisis: Part of the Problem or Part of the Solution?

3.1 Brief review of the crisis

The financial crisis, although triggered by the collapse of the US sub-prime market, can be traced back to a complex conjunction of underlying causes and drivers, both at the global macroeconomic and at the microeconomic level. Ample liquidity and low interest rates were major underlying factors. But financial innovation, regulatory and supervisory gaps, weaknesses in risk management, and corporate governance failures and accounting weaknesses amplified and accelerated the consequences of excess liquidity and credit growth.⁷

Monetary policies across the globe were rather easy in the years leading to the crisis. What began as a monetary policy reaction to the bursting of the dot-com bubble in 2000 sowed the seeds for an extended period of excess liquidity. Taylor (2007) demonstrates that, from mid-2001 to 2006, monetary policy in the US was too easy relative to the Taylor rate. Applying the same Taylor-rule estimates to the euro area, and with the benefit of hindsight, Elmeskov (2009) concludes that interest rates were somewhat lower than warranted by the cyclical position of the economy in the euro area.

Strong global macroeconomic growth since the mid-1990s had nourished an illusion that such high and practically inflation-free growth was always possible. At the same time, the increasing integration of the People's Republic of China (PRC) and other emerging markets in the global economy was exerting global pressure on commodity prices and restraining price and wage increases in the industrialized countries. Excess liquidity was plowed instead into credit, inflating asset prices and unbalancing the global financial markets.

The global growth model—excess consumption in the US and excess savings in the PRC and other emerging market economies, including oil-exporting countries—worsened the liquidity glut. With interest rates at record lows, personal saving in the US fell from 7% of disposable income in 1990 to below zero in 2005 and 2006. Consumer credit and mortgages ballooned. The private sector borrowed heavily. In the US the credit expansion was financed partly by massive capital inflows from emerging economies with current account surpluses, notably the PRC. Such surpluses, which had accumulated through currency pegs, were recycled into US government securities and other lower-risk assets and thus added to an overall compression of yields.

The combination of high liquidity and low interest rates, coupled with compressed volatility in many key markets, drew investors to ever-riskier assets that promised higher yields. Easy credit and rising asset prices contributed to low default rates, which reinforced the perception of low risk. As a result, risks became systemically mispriced and leverage reached an unprecedented scale. A number of factors on the microeconomic side amplified this trend.

Significant technological change and product innovation in financial markets had led over the years to the creation of increasingly complex financial products that were bought worldwide. The securitization, packaging, and trading of loans and assets changed the relationship between banks and customers and reduced the incentives for lenders to comply with proper lending standards. These new instruments allowed market participants to take on more debt and at the same time posed significant challenges to the management of risk, both for the individual financial institutions and for the public supervisors. The complexity and dramatic growth of these instruments prompted a great reliance on the assessment of credit rating agencies, some of which had actually designed and promoted the use of such instruments.

In an environment of intense market competition, the incentive structure of managers in financial institutions encouraged excessive short-term risk taking as they were paid for short-term successes while problems showed up only over time.

The supervisors did not pay enough attention to a number of relevant financial market features, such as off-balance-sheet activities, the risks of new instruments, the implications of the changing model of credit distribution, and liquidity risks. Neither the supervisors nor the credit agencies thought it likely that market confidence could suddenly evaporate and certain categories of instruments could no longer be sold at any reasonable price.

Perhaps most importantly, the supervisors did not take macroeconomic and macro-financial stability aspects, including global ones, sufficiently into account. Though effective at the surveillance of individual institutions, the supervisors were not used to assessing macro-prudential risks. In addition, the global inter-linkages were poorly understood by a supervisory structure organized basically along national boundaries. This was true for the United States, and also for the EU, where this reflected—in part—weak cross-border coordination of regulation and supervision. In the EU, the rapid growth in the cross-border activities of banks, including those in Central and Eastern Europe, underlined these weaknesses.

Finally, accounting rules, whose pro-cyclical impact turned out to be worse than expected, made the downward spiral more severe.

The dramatic repercussions of the financial sector crisis are well known. After a spate of bank failures in the US, the crisis intensified sharply as confidence in the financial markets crumpled and the flow of credit to the economy ground to a virtual halt. Market sentiment nosedived worldwide, and global production and world trade, after years of stellar growth, collapsed. As a result, the global economy at the end of 2008 was in its deepest and most widespread recession in the postwar era.

The euro area was particularly hard hit. The European Commission, in its autumn 2009 economic forecast, projected a decline of about 4.0% in euro-area GDP for the year, compared with a 2.5% contraction for the US and 5.9% for Japan. This has raised the question whether the euro area can weather the storm or whether the euro has further facilitated the spread of the crisis in Europe. Some commentators have even expressed doubt that EMU would survive unscathed.

3.2 Has the euro facilitated the spread of the crisis? No, but…

The current events have highlighted the advantages of a single currency and demonstrated the benefits of deepening euro-area policy coordination. Thanks to the successful first decade of EMU, the euro area and its Member States are today in a much better shape to weather these truly testing times than ever before. The euro is limiting the impact of the crisis in Europe and providing stability in several ways. First, it has prevented the exchange rate and interest rate turbulences among the euro-area Member States that used to be common during periods of financial stress in the past. We know from experience how damaging such intra-European currency turmoil can be for the functioning of the Single Market. Second, as argued in section 2, the euro area's stability-oriented macroeconomic framework has reduced the level and volatility of inflation and interest rates, as well as output fluctuations. Third, overall successful consolidation of budgetary deficits in most Member States in recent years, even though imperfect, has created room for fiscal policy to play an important stabilizing function in the crisis. Fourth, since the start of the financial turmoil in 2007, the ECB has adopted an accommodative monetary policy stance and has skillfully managed liquidity. This has helped to ease conditions in the interbank market and to anchor inflation expectations throughout this period of uncertainty. Finally, the governance structure of EMU, while far from being perfect, has facilitated policy coordination across the euro area and the European Union as a whole. The close interaction of all actors involved in the Eurogroup and in the Ecofin Council has spurred a swift and bold policy response to the global economic and financial crisis.⁸

Imagine for a moment how the crisis might have unfolded in the euro area without the euro. The coordination problems would have multiplied. Sixteen European central banks would have had to struggle for coordinated liquidity provision while trying to keep exchange rates and inflation expectations in check, and negotiate currency swaps with the US Federal Reserve.

However, the crisis has also revealed important weaknesses and vulnerabilities in the euro area. It has exposed in particular the vulnerability of Member States with significant macroeconomic imbalances, and underscored important shortcomings in the European regulatory and supervisory framework and in cross-border crisis resolution arrangements.

3.2.1 The role of intra-euro-area imbalances

The accumulation of large current account imbalances and divergent competiveness developments have rendered some euro-area member states particularly vulnerable to the fallout from the crisis. Partly favored by low real interest rates, the euro area over the last 10 years has experienced substantial growth differences among Member States (Figure 3 [ PDF 14.5KB | 1 page ]). Growth differences should pose no major problem for a monetary union if they are part of the normal catching-up process or a reflection of differences in population growth. However, they can become a problem if the differences are due to more enduring differences in competitiveness. As demonstrated by the evolution of intra-euro-area current accounts and real effective exchange rates (Figure 4 [ PDF 28KB | 1 page ] and Figure 5 [ PDF 16.5KB | 1 page ]), there was substantial divergence in competitiveness within the euro area at the start of the crisis. Recent research done by the European Commission identifies three groups of countries: (i) those with large current account deficits and significantly overvalued real effective exchange rates (notably Spain, Greece, and Portugal); (ii) countries with large current account surpluses and various degrees of real exchange rate undervaluation (Germany, the Netherlands, Finland, Luxembourg, and Austria); and (iii) countries with a worrying propensity for weak export growth and falling export market shares (Belgium, Ireland, France, and Italy).⁹ Whereas Germany since 1999 has continuously increased its price competitiveness with respect to the euro average, the relative competitiveness of the initial boom economies, including Spain, Portugal, Greece, and also Ireland, has increasingly deteriorated.

The differences in price competitiveness are driven partly by an inappropriate response of wages to country-specific productivity shocks in some Member States, and in some cases by the buildup of financial and macroeconomic imbalances linked to excessive domestic demand pressures. As a result of these imbalances, private sector and external debt have surged in the deficit countries (Figure 6 [ PDF 18.5KB | 1 page ]). The importance of the imbalances is compounded by the fact that in some of these countries a substantial share of the capital inflow was not used for productive investment, but went into the real estate sector, where it contributed to the rise in asset prices and the development of excess construction capacities. All these factors, together with, in some cases, the buildup of short-term debt and large financial sectors, increased the vulnerability to abrupt changes in financial market conditions.

With the crisis-induced downturn in credit, coupled with a drastic fall in housing prices and the need to engineer substantial economic adjustment, the economic prospects and the public finances of these countries have been particularly hard hit. GDP has been forecast to shrink by 7.5% in 2009 and 1.4% in 2010 in Ireland, and by 3.7% in 2009 and 0.8% in 2010 in Spain. Deficits are projected to increase to 12.5% of GDP in Ireland and 11.2% in Spain. But the crisis is affecting not only the deficit countries. The contraction has been among the deepest in some surplus economies with particularly strong export sectors, including Germany, where GDP has been projected to shrink by 5.0% in 2009, Finland (by 6.9%), and the Netherlands (by 4.5%).¹⁰

Excessive borrowing in foreign exchange in some non-euro-area Member States and its potential repercussions are another source of concern for the euro area. External borrowing, in particular in euro but also in other foreign currencies, has created huge currency mismatches and balance-sheet risks in a number of EU economies in Central and Eastern Europe. A substantial share of this debt financed unsustainable real estate booms, which are now being drastically reversed. As a result, some of the countries are facing very sharp drops in activity, pressure on exchange rates, and severe balance-of-payment problems. The exposure of euro-area banks in the region has made some smaller euro-area Member States in particular more vulnerable to the economic developments in these countries.

3.2.2 Overhaul of the EU financial market supervisory framework

Finally, the financial crisis has highlighted weaknesses in the EU's supervisory framework. The outbreak and magnitude of the crisis caught financial market supervisors largely by surprise, not only in the US but also in the EU, pointing to serious limitations in existing frameworks. Macro-prudential risks, both in individual countries and in the EU, were not emphasized enough. Even where such risks were identified, there was no effective mechanism for corrective action.

The European Commission had long argued that the integration of European financial markets needed to be accompanied by improved cross-border arrangements for prudential supervision, crisis management, and crisis resolution. However, 10 years after the introduction of the euro, supervision remains largely fragmented along national lines despite the ever-growing importance of cross-border financial activity, including the pan-European trading of sophisticated financial products. Around 70% of EU banking assets are held by 43 cross-border banking groups. While the so-called Lamfalussy approach, which started in 2001, helped speed up the adoption of EU financial services law, progress was much slower on the supervisory side. For instance, no common reporting formats for banks were agreed on. Even though a better pan-European supervisory system might not have prevented the crisis from hitting Europe, the insufficient flow of information between national supervisors and the absence of a robust framework for the management and resolution of a crisis did not make it any easier to limit the spread of the crisis and led to the initial restructuring of financial institutions along national lines.

With this widely shared assessment in mind, the European Commission invited Jacques de Larosière to help develop proposals for an overhaul of the framework for financial supervision in the EU, as head of a high-level group.¹¹ The commission has begun translating the group's recommendations into concrete legislative proposals. Drawing on the lessons from the crisis, the proposals foresee a two-tier supervisory structure, including the creation of a European macro-prudential risk board chaired by the president of the European Central Bank and a European system of financial supervision, with binding powers to mediate and settle conflicts between national regulators.¹²

Response of the European Union to the Economic and Financial Crisis

The European Union (EU) has responded quickly to the most severe global economic crisis in 80 years, taking substantive measures to stem the crisis, both to restore the functioning of financial markets and to support the economy. The European Central Bank and other central banks cut interest rates and injected ample liquidity into the system to prevent the interbank market from grinding to a halt.

Threatened by the specter of systemic bank failures in the wake of the Lehman Brothers bankruptcy, governments swiftly adopted bold rescue packages in October 2008. These packages typically combine far-reaching guarantee schemes, deposit guarantees, capital injections, and in some cases the purchase of impaired assets and the temporary nationalization of banks.

Quick and decisive action was needed to prevent the downturn in the real economy from affecting the financial sector, and in turn the financial sector from constraining the real economy further. The European Commission therefore issued on 26 November 2008 a communication on a European economic recovery plan, which was broadly endorsed by the European Council of 12 December. The immediate priority of the recovery plan is to secure full confidence in the financial system and to mitigate the potential impact of the crisis on the real economy. The recovery plan rests on two main pillars: (i) a major budgetary impulse of €200 billion (1.5% of EU gross domestic product), made up of €170 billion in budgetary expansion by Member States and €30 billion in EU funding for immediate actions, to boost demand; and (ii) priority actions, grounded in the Lisbon Strategy, and designed at the same time to adapt the EU economies to long-term challenges and to continue implementing structural reforms aimed at increasing potential growth. A first assessment of the recovery plan shows that the implementation of the measures has been effective and timely.

Finally, the EU is working on an overhaul of its system of financial supervision and regulation. Most importantly, the de Larosière report forms the basis for the strengthening of European cross-border supervision and regulation. The European Commission has presented detailed proposals based on the report of the high-level group chaired by de Larosière to the Council and the European Parliament with a view to reaching agreement on the new structures to be set up in 2010. Moreover, comprehensive work on the reform of the regulatory framework of the EU financial market is under way, also feeding the debate at the global level in the context of the G20.

For further details, see European Commission (2009a).

3.3 Does the euro provide a shield in the crisis? Yes but…

The euro provides an effective shield against the crisis. Euro-area members have benefited in particular from the ECB's swift and decisive liquidity management. From the onset of the financial market tensions, the ECB has taken forceful action in liquidity management, including nonconventional measures, to make sure that banks can refinance themselves.

The ECB reduced its benchmark policy rate by 325 basis points to 1.00% between October 2008 and May 2009, and has kept it stable since then to cushion the impact of the financial crisis on the real economy against the backdrop of receding inflationary pressures. In addition, it implemented a range of nonstandard measures, such as enhanced liquidity provision via fixed-rate tenders with unlimited supply (including the introduction of very-long-term refinancing operations with a maturity of 12 months), looser collateral standards, provision of foreign currency liquidity, and purchases of covered bonds. These measures have successfully supported the functioning of both money and covered-bond markets in the euro area. They have ensured that banks have adequate access to central bank funding to continue financing the economy. Moreover, they have prevented major liquidity constraints and reduced the risks of a systemic crisis. The new Member States that have already adopted the euro have also benefited. Malta, Cyprus, and Slovenia have been largely shielded from the impact of the turmoil and liquidity shortages. Slovakia, which adopted the euro in January 2009, has also weathered the financial storm well. The euro has thus acted as an umbrella against possible liquidity strains that would otherwise have affected the smaller, and less credible, pre-euro currencies.

However, despite these important shielding functions, the various weaknesses and in particular the macro-financial vulnerabilities described in the previous section have increased macro-financial tensions within the euro area. These tensions have become most visible in the rapid surge of sovereign bond spreads in the area.

With the onset of the crisis, the spreads of sovereign bonds increased to levels not seen since the inception of the euro (see Figure 7 [ PDF 61.9KB | 1 page ]). While underlying imbalances play an important role, much of the recent rise in spreads seems to be due to a general repricing of risk. Much of the widening of spreads appears to have been a rather general phenomenon across a broad range of asset markets.¹³ The risk of many assets, including government bonds, has been significantly repriced in the course of the crisis. For instance, corporate bonds have seen a similar widening of spreads across different risk classes (see Figure 8 [ PDF 61.9KB | 1 page ]). Assuming that risk was underpriced before the crisis, it could be argued that at least part of the observed increase in government bond spreads can be interpreted as a return to the normal functioning of markets. A longer-term view of the evolution of spreads shows that even during the most intense phase of the crisis for most Member States the spreads stayed below the levels seen before the start of the euro (see Figure 9 [ PDF 32.5KB | 1 page ]).

Moreover, the widening in spreads has not led to a corresponding rise in financing costs since the start of the euro because the yields for the underlying benchmark, the German bond, decreased significantly during the financial crisis. It fell from 4.3% in the second quarter of 2008 to 3.1% in the first quarter of 2009, followed by a broad stabilization (at some 3.3% in mid-October). The decrease in German yields during the crisis can be related to lower growth and inflation expectations and the associated monetary loosening of the ECB, but reflects also some flight-for-liquidity effects as the German capital market is perceived to be deeper, safer, and more liquid. As a result, even at the peak of the crisis, long-term government bond yields in most euro-area countries were not significantly higher than they were in the pre-crisis period. Marked exceptions are Greece and Ireland, where market concern about the sustainability of public finances and the scope of adjustment needs contributed to a particular strong rise in spreads. However, even in these two countries, the yield on government bonds is now back below the pre-crisis level.

Overall, the long-term borrowing environment still represents a major benefit of EMU membership in the current crisis. In particular for the periphery countries, in the absence of the euro, investors would have demanded much higher interest rates to compensate for the higher credit default and exchange rate risk as a result of the crisis.¹⁴

Despite this relatively reassuring assessment, some authors, stunned by the scope of the crisis, have evoked the specter of euro-area disintegration. What are the arguments and how real is the risk of a euro-area breakup?

3.4 The specter of euro-area disintegration: Old and new myths

There can be no doubt: the ongoing global financial and economic crisis is a serious test for EMU. However, it is so from a rather unexpected angle, and the risks of breakup are far-fetched. Early EMU skeptics wondered if and how the euro area would survive asymmetric shocks affecting individual Member States in the context of a single monetary policy and exchange rate. Many found the euro area lacked the textbook criteria for a successful currency union, such as high intra-area mobility of labor and a centralized fiscal stabilization scheme. Yet, with the global crisis a massive shock is hitting all Member States simultaneously, although with a differentiated impact depending on the starting conditions.

As argued above, in a number of Member States the crisis has unearthed substantial adjustment needs to regain competitiveness, which will be much more challenging and economically painful to realize in a global environment of slow growth than in a period of dynamic economic expansion. This has led old and new skeptics to express doubts about the cohesion and viability of the euro area. For instance, Feldstein (2008) reasons that common economic policies, including the ECB's area-wide monetary policy and fiscal policies guided by the Stability and Growth Pact, might be perceived as ill suited for the welfare of individual countries. Tilford (2006) argues that widening current account deficits and losses in competitiveness could combine into a vicious circle, in which weak competitiveness generates low growth, which in turn leads to a protracted deterioration of the country's economy.

Much along the same line, Hankel, Schachtschneider, and Starbatty (2009) argue that economic divergences within EMU, driven by uncontrolled public deficits and deteriorating competitiveness, could undermine the entire European Union project. In their view, the notorious discrepancy between high- and low-performing Member States ultimately creates a policy dilemma that leaves only three options. The low performers would have to engage in permanent austerity polices, including repeated cuts in wages and social standards (option 1). However, such an option would hardly be politically viable and ultimately undermine the support of the Single Market project altogether. Alternatively, Germany, being the wealthiest high performer, would have to sustain the low performers (option 2). However, such an approach would have detrimental moral hazard effects, and would neither accord with the Treaty. Hankel et al. conclude that, to regain competitiveness, euro-area Member States with structural competitiveness disadvantages should exit the euro area and devalue (option 3).

In light of the potentially precarious economic and financial situation of some Member States, others, for instance, O'Grady (2009), see the lack of a lender of last resort as a significant source of weakness for the euro area. Finally, skeptics put in doubt the political governance of EMU. In view of its failure to spur structural reform, Tilford (2006) considers, in line with Feldstein (2008), that pressure for structural reforms might either generate rising tension between governments, or generate social and political unrest, ultimately inducing policy makers to opt for an exit from the euro area. Pisany-Ferry and Sapir (2009) do not predict a euro-area breakup, but criticize the absence of a sufficiently effective euro-area crisis management capacity. Judging the overall euro-area governance system as weak, they see it in particular as a handicap making it difficult for the euro to gain further influence as a global currency.

Many of the arguments presented in these critical assessments are not new.¹⁵ While they have to be taken seriously, they tend to overstate the risks implied by the intra-euro-area competitiveness divergences and to ignore the euro area's successful track record over the last 10 years. Concerns of a euro-area breakup based on competitiveness are overstated for several reasons.

First, the observable evolution of competitiveness and current account imbalances has to be kept in perspective. Competitiveness assessments depend significantly on the choice of the base year. Using the year 2000—the first year after the introduction of the euro—as a base year clearly emphasizes the strong gains in competitiveness of Germany (22 percentage points over Italy in 2008).¹⁶ Taking 1990, before the effects of German unification set in, as starting point for comparison yields a different picture of relative competitiveness positions. Italy increased its competitiveness edge over Germany in the 1990s. It was not until 2000 that Germany began to regain lost ground. If 1990 is taken as baseline, Germany's real effective exchange rate (REER) had gained 4.8% by 2008, while Italy's REER had gained 6.4%.

Second, current account divergences are, at least to some extent, the result of faster growth in lower-income countries and thus reflect successful catching-up and integration in EMU. ¹⁷ Moreover, the ongoing downturn reduces current account imbalances as it adjusts relative demand across Member States. Current account surpluses and deficits of euro-area Member States are expected to drop by about one-third between 2008 and 2010. Because of the current slump in domestic demand among deficit countries, a fall in the price of non-tradable goods will make investment and production in the tradable sector more profitable, thereby providing support for the current account. Likewise, Germany will not be able to maintain its large trade surplus at a time when world trade falls significantly.

Overall, this does not mean that the more entrenched part of current account deficits should be disregarded. To the contrary: differences in competitiveness, budget situations, and current accounts are real. They need to be tackled through structural reforms. That is not easy, but it is possible. Member States are increasingly aware of their need to adjust. Recognizing the common interest in addressing macroeconomic imbalances, the Eurogroup has embarked on the broadening of its surveillance of Member States' economic policy development to strengthen peer support for reform.

3.5 The true costs of exiting the euro area

Would leaving the euro area solve the pending competitiveness challenges as some propose? Legal, political, and more importantly economic considerations demonstrate that exit is no viable solution to prevailing policy challenges. According to the Treaty, joining the single currency was and is an irrevocable step. Article 4(2) of the Treaty refers to the “irrevocable fixing of exchange rates leading to the introduction of a single currency.” Article 123(4) refers to the “conversion rates at which their currencies shall be irrevocably fixed.” Beyond legal matters, exiting the euro area would bear considerable economic and political costs, both for the Member State concerned and for the euro area as a whole, which are often overlooked.

For countries with competitiveness challenges, exiting the euro would be tantamount to a very significant devaluation of the new currency in a bid to regain lost competitiveness. However, for a number of reasons such a move would backfire and be politically self-defeating. While an exit from EMU coupled with devaluation might give a temporary boost to national exports, the population would experience a loss of purchasing power with the currency devaluation and the likely increase in inflation. Possible protectionist reactions by trading partners could further undermine the desired effects. Moreover, the underlying structural problems would remain unaddressed, and the incentives for reform would probably weaken. Perhaps even more importantly, devaluation would lead to an increase in real government debt or re-denomination, tantamount to a practical default on government debt; both options would be costly for the government as well as the population. By the same token, negative balance sheet effects in the private sector would further dampen growth.

There are also practical considerations that make the breakup of the euro area a rather remote option. Introducing a new currency is costly in terms of time as well as confidence. This starts with the inevitable complex and controversial political discussions surrounding the decision to make such a move, which would adversely affect confidence and ultimately the real economy. A new currency would need to be printed and brought into circulation; this cannot be done overnight. The exit argument overlooks the fact that the financial environment has dramatically changed over the last 2 decades. In a regime where capital flows freely, the process of leaving the euro would lead to large capital outflows, further undermining the stability of the economy. The new currency would be under heavy speculative pressure from financial markets. The authorities would either have to raise interest rates to high levels, choking the economy in the process, or let the new currency devalue further. Undershooting of the desired exchange rate, possibly over a considerable period, would be likely.

Finally, the repercussions on the relationship with other partner countries in the EU would be incalculable. In addition to potential protectionist reactions and the destabilizing impact on the Single Market, an exit from the euro area, the deepest form of European integration, is likely to be seen as a signal of intention to leave the European Union altogether. However, despite widespread complaints about “Brussels”-induced regulations and notoriously low ballot turnouts in elections for the European Parliament, EU membership is highly popular among European citizens across all countries.¹⁸

Against the foregoing background, it is not surprising that, rather than enticing members to exit, the crisis has further increased the attractiveness of the euro, even among those Member States that are not yet part of the euro area.

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