The (never-ending) Eurozone
Crisis
J. Lawrence Broz
Associate Professor of Political Science
UCSD
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Europe’s Bleak Outlook (est. 2015)
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Scariest Graph in the World
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When young people lose faith in the
economy, political chaos usually
follows
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Consider The Great Depression
• The Great Depression of the 1930s bred
support for extremist ideologies that
advocated the overthrow of the political
system
– e.g. National Socialists in Germany, Iron Cross in
Hungary, the Iron Guard in Romania, communist
parties in many countries
• Recent research shows that the share of votes
for extremist parties in elections in 1930s
correlates strongly with economic hard times
Source: Alan de Bromhead, et al. “Political Extremism in the 1920s and 1930s:
Do the German Lessons Generalize?” Journal of Economic History (July 2013).
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Lecture Outline
• Origins of the Euro Project
– Political motivations for European economic
integration
– Path toward monetary union
• Weaknesses that lead to the crisis
– EU not an “optimal currency area”
– Eurozone banks viewed the creation of the
euro as an implicit bailout guarantee
• The Greek Debt Crisis
– Bargaining and Bailouts
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Origins of the Euro Project
• Creation of the euro—or “Economic and
Monetary Union” (EMU)—is the latest step
in a long process of politically motivated
economic integration
• After World War II, the U.S. and the political
leaders of France and Germany sought to
bind the former antagonists economically, so
as to ease Franco-German tensions and build
a bulwark against Soviet expansion
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European Coal and Steel Community
• Coal and steel had been the source of conflict
between Germany and France for a century
– they had battled over the coal of the Ruhr, iron
the Lorraine, and steel mills of the Saar since 1870
• With the backing of the U.S. and in the
shadow of the Cold War, the French came up
with the “Shuman Plan” for inducing FrancoGerman cooperation in this area
• French foreign minister Robert Schuman said
the aim was to "make war not only
unthinkable but materially impossible.“
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European Coal and Steel Community
• ECSC (1951) marked the birth of Europe--its first
supranational institution
• It’s members—France, Germany, Belgium, the
Netherlands, and Luxembourg—were bound under a
joint authority, with a common market and common
regulations
• ECSC was a remarkable accomplishment given that
France and Germany were at war a few years earlier
• It also provided the model for further integration and
was followed in 1956 by the European Economic
Community (EEC) which extended the common market
and built a customs union within Europe
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History of the Euro
• To promote greater cooperation and further
integrate their economies and, Europeans
sought to minimize the variability of their
exchange rates
• In 1979, the European Monetary System (EMS)
linked EU member currencies to the
Deutschemark in a fixed-rate regime
• In 1992 Maastricht Treaty, EU members agreed
to create a common currency (the euro)
managed by a single authority, the European
Central Bank (ECB)
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Transition to the Euro took 8 years
• Maastricht Treaty (1992) committed countries
to fiscal discipline prior to the rollout
– Reduce national budget deficits to within 3% of
GDP, and government debt could not exceed 60%
of GDP
• Most countries failed to heed these rules
– Even Germany and France breeched rules 3 years
in a row
• Nevertheless, the Eurozone was created in
1999 and the physical currency was rolled out
in 2001
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Economic Benefits of Currency Union
• Having many currencies is costly because it
impedes the flow of goods and capital across
borders
• Thus, a key benefit of currency union is that it
encourages trade and financial integration
– Europe was to be like the United States, with its
single currency and its single central bank
• In the context of Europe’s continuing quest for
greater economic integration, a currency
union seemed the next logical step
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Economic Costs of Currency Union
• The main cost is that a nation gives up one of the
most powerful tools of macroeconomic
management: a flexible exchange rate
• A flexible exchange rate is a kind of
macroeconomic “shock absorber” that allows
governments to adjust policy to changes in
economic conditions
– e.g., if demand for U.S. goods decreases, a weakening
of the U.S. dollar (which makes U.S. goods cheaper
for foreigners) can help offset the negative impact on
the economy
• Adopting the euro meant that EU nations gave up
this shock absorber
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When do the benefits of currency
union outweigh the costs ?
• “Optimal Currency Area” (OCA) criteria:
– When members have sufficiently similar
economies such that a “one size fits all” policy is
appropriate
– When labor mobility among members is high
• e.g., in the U.S. people move from where
unemployment is high to where it is low
– When members are part of a fiscal union
• e.g., in the U.S. , unemployment insurance flows to
areas that face region-specific shocks
• Europe did NOT meet any of these criteria…
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So why did the project proceed?
• Currency union was desirable because it
furthered political integration within
Europe, which was the point all along
– Members also thought they could approximate
OCA criteria with a steady flow of EU edicts aimed
at increasing cross-country labor mobility
• Powerful business and banking interests
with major cross-border economic ties
supported the project
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Underlying Weaknesses
1. EU was NOT an Optimal Currency Area. It is
composed of two different types of economies:
– “Core” (Germany, France, the Benelux countries,
Austria, Finland)
– Periphery” (Greece, Ireland, Portugal, Spain, Italy,
Cyprus)
2. An implicit “bail out” guarantee that loosened
borrowing constraints for the periphery
– Core banks made risky loans to the periphery
because they believed a bailout would be
forthcoming if a member state got into trouble
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Calm before the storm
• From 1999 to 2007, the Eurozone faced a
benign economic environment
– The nation-specific economic problems that
occurred were not so serious as to call into
question the integrity of the Eurozone
• But underlying problems grew…
– Lending from Core to Periphery fueled
housing bubbles in Spain and Ireland, and a
massive public debt buildup in Greece
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10 year yield on Government Debt
Implicit bailout guarantee and the
“disappearance of risk”
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Variety of crises, but a Common Cause
• Foreign borrowing was the common cause but
there were a variety of failures
• Greece’s problem was fiscal policy and a large
government debt
– Foreign borrowing financed generous public sector
pay, welfare, and retirement benefits
• Ireland and Spain were fiscally responsible but
their banks lent the foreign money to property
developers, generating massive housing bubbles
– When the housing bubbles burst, governments
assumed the debts via bank bailouts (sound familiar?)
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Onset of the Crisis
• Benign environment gave way to the Great
Recession in 2008 which shook confidence in
lending to the periphery
• As their debts mounted, foreign banks
became doubtful that peripheral countries
could repay, which forced interest rates
higher—a vicious circle
• With news in 2010 that Greece had hidden
the truth about its problems, lending to the
periphery stopped altogether—a “sudden
stop” that marked the onset of the crisis
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Risks beyond Greece
• If peripheral countries like Greece can’t
borrow to rollover their debts, they will
be forced to default
• If Greece defaults, it could trigger other
defaults
• If a defaults occur, it could bring down the
entire European banking system since
banks in the Core are heavily exposed
– If a nation defaults on its foreign debt, the
banking systems of creditor nations face
large, perhaps fatal, loses
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The Core’s Banks are on the Hook
Foreign banks combined consolidated claims on Greece,
Ireland, Italy, Portugal, Spain (% GDP)
40
% GDP
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20
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0
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Greek Debt Crisis
• In 2010, the EU faced the choice between
Greek default or a bailout
• The EU (and IMF) chose a bailout - €146 billion
to Greece over 3 years in installments
• In 2012, the “Troika” (EU, IMF, ECB) provided a
second bailout worth €130 billion. The terms:
– Greece has to impose austerity: hike taxes,
cut public sector salaries, pensions, etc
– But there was debt restructuring too: banks
in the core agreed to debt reduction of 53%
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Debt Crisis Bargaining
• Countries in the core square off with debtor
countries in the periphery to see who will
bear the burden of adjustment
• A “morality play” over who is responsible:
– Creditors blame debtors for and “living
beyond their means.” Derisively “PIIGS.”
Creditors demand debtor austerity to maintain
debt service
– Debtors blame core banks for making huge
profits on risky loans and they demand debt
restructuring to make their debt burdens more
manageable
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Outcomes Depend on Relative
Bargaining Power
• Core’s leverage: Since private loans are not
available, official creditors (EC, IMF, ECB) have
leverage over debtors
– Without their loans, a debtor government can’t
pay its bills, leading to economic and financial
collapse and an existential socio-political crisis
• Periphery’s leverage: since core banks hold so
much of the periphery’s debt, defaults pose
an existential threat to the core’s banking
systems
– This give the periphery substantial leverage
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Muddling Through
• The EU has muddled through each new
crisis—Cyprus being the most recent—with
outcomes reflecting a mixture of austerity
and debt restructuring (creditor “haircuts”)
• Despite their differences, the core and
periphery are mutually dependent, which
explains why they have found compromises
and avoided disaster
• No one wants to see the Eurozone collapse
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Reasons for Optimism
• They EU has fixed some of the underlying
problems by way of new treaties
– “European Stability Mechanism” (2012) can
provide instant financial assistance . It has €500
billion in resources
– “European Fiscal Compact” (2013) creates
stronger fiscal discipline
• Public opinion throughout the EU remains
strongly committed to the Euro
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Public opinion is surprising resilient
Pew Research Survey conducted in March 2013
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Towards Political Union
• “Political union” is often presented as the
culminating and final stage of European Union
• The irony is that the crisis has fostered a lot of
political union— the decisions made recently
to reinforce fiscal, economic, and financial
governance are significantly fostering political
union
• Recall Shuman: “Europe will not be made all
at once, nor according to a single plan.”
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End
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What happens when a country defaults
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