Eurozone Crisis: Causes and Consequences

The European Project has always been more or less ambiguous about its objective. The famous Schuman Declaration of 9 May 1950, considered to be the guiding principle behind the European project, is without doubt the clearest of the founding texts. It assigned the six signatory states the objective of achieving, through the European Coal and Steel Community, “the setting up of common foundations for economic development as a first step in the federation of Europe”. Federation was what it was all about.

At the end of the Second World War, the goal was to create a peaceful region, for that France and Germany relied on economic agreements to achieve it. These two nations were fighting with each other for two raw materials which were coal and steel. That is how the European Coal and Steel Community was built. Building a single market around these two industries was the best way to avoid any tensions and at worst war between European countries. Later, the Treaty of Rome established the European Economic Community. This union was based on the customs of the six main countries of the area, namely, France, West Germany, Luxembourg, Belgium, Italy and the Netherlands. The abolition of customs duties allowed for the free movement of goods and marks the beginning of convergence between these countries. The aim of this paper is to present the reason for the Eurozone crisis, which factors led to this crisis, what were the consequences of this crisis, is there still some impact today and what is the future of Europe, with or without a common currency.

History of the Eurozone

The Euro was born of the decision of the European Union leaders to establish an Economic and Monetary Union, with a single currency, under the Maastricht Treaty signed in 1992. But first it was in June 1988, that the European Council announced its intention to establish an Economic and Monetary Union. The former president of the European Commission, Jacques Delors, was asked to form a committee to study the stages of progress. The Delors’ report, published the following year in three phases. The first one is the strengthening of monetary cooperation and the complete liberalization of capital movement. Then, the next phase was the creation of the European Monetary institute. And the third phase was the irrevocable fixing of exchange rates and the introduction of the Euro.

The first stage in the construction of the Economic and Monetary Union began in 1990 with the decision of the European Council to give new responsibilities to the Committee of Governors of the Central Banks of the member states of the European Economic Community. In fact, during this phase, the European Council was to bring the different national monetary policies closer together, in order to arrive at the fixing of conversion rate between currencies, planned for the third phase. The Committee’s new tasks are, therefore, to consult and promote the coordination of member states’ monetary policies. In addition, this first step towards the establishment of the Economic and Monetary Union includes extensive legal work to amend the Treaty of Rome. To this end, an intergovernmental Conference on the Economic and Monetary Union was convened in 1991. This was held at the same time as another political union. The result of these negotiations is probably one of the most important treaties in the history of the European integration, the Treaty of Maastricht, also known as the Treaty on European Union. The Maastricht Treaty sets out, among other things, the five convergence criteria which govern a member state's entry into the future monetary union.

The second stage of the Economic and Monetary Union began with the establishment of the European Monetary Institute. This institution was a temporary one which replaced the European Monetary Cooperation Fund and whose objective was to pursue the monetary integration of the community with a view to the creation of the European Central Bank. The European Monetary Institute was not responsible for the conduct of monetary policy (which remains a national prerogative) and cannot carry out foreign exchange interventions. It is responsible for further strengthening coordination between central banks and for preparing the creation of the European System of Central Banks. During this second phase, the European Council decided on the name of the new single currency, the Euro, while the European Monetary Institute presented the selected designs of the banknotes. In 1997, the European Council adopted the Stability and Growth Pact, which consists of two parts (preventive and corrective) and aims to ensure budgetary discipline in the Economic and Monetary Union. The Council of the European Union meeting with the heads of states and government voted unanimously that eleven member states fulfilled the necessary conditions to adopt the single currency.

The third phase started when the European Central Bank took over from the European Monetary Institute and eleven member states entered the third stage, namely Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. This group, now known as the ‘Eurozone’ expanded, later, with eight new member states (Greece, Slovenia, Cyprus, Malta, Slovakia, Estonia, Latvia and Lithuania). In theory, all the EU countries are supposed to participate in the Economic and Monetary Union and eventually join the Eurozone. However, two countries have a derogation. Denmark refused to commit to EMU from the outset and Sweden has an informal ‘opt-out’.

The Eurozone Crisis

The economic and financial crisis that broke out in 2008 highlighted the need to strengthen economic governance in the EU and the Eurozone. The crisis led member states to put in place new, and more precise and effective common policy instruments. These reforms, which have been the subject of several summits, have concerned all three strands of the Economic and Monetary Union: monetary, economic and fiscal. The stability of the single currency has, for long, been put to the test during the crisis, and the scholars has repeatedly questioned the future of the Euro. The economies of several member states have been badly hit. Indeed, national deficits and debt levels have far exceeded the rules set out in the Maastricht Treaty. The EU has put in place rescue packages to replenish national coffers. At the same time, member states discussed deepening the Economic and Monetary Union reaffirm the Maastricht principles and ensure better economic and monetary coordination.

In 2011, the European Semester came into force. It is a new tool for budgetary and economic coordination and surveillance. The EU decided to strengthen the Stability and Growth Pact adopted in 1997, the so-called ‘Sixpack’ reform imposes quasi-automatic procedures in case of infringement of the rules and the introduction of graduated financial sanctions.

In 2008, Ireland became the first country in Europe to go into recession. Its GDP fell by 3,5% and its public deficit reached 7,2% of GDP, far exceeding the 3% standard imposed by the Maastricht Treaty. Within the EU, Spain and the United Kingdom will follow. The years 2008 and 2009 can be considered as the hardest, since the GDP of the EU-28 grew by only 0,5% in 2008 before posting a negative growth of 4,3% the following year. It was not until 2010 that growth picked up again (2,1%), before another recession in 2012 (-0,4%). Faced with systemic risks, the reaction of European institutions was swift. After the collapse of Lehman Brothers, the European Central Bank gradually lowered its key rate from 4,75% to just 1%.

The Eurozone crisis of 2008-2009 is first and foremost a banking crisis, caused by risky innovations, in a context of uncontrolled financial liberalization and globalization. It was not caused by rising public debts and deficits. However, it did cause a sharp deterioration in public finances, due to support for banks, failing tax revenues and policies to support activity. From the end of 2008, the financial markets speculated on the break-up of the zone. The financial crisis has been prolonged into a crisis of public debt in the Eurozone. The crisis has led to a sharp rise in the public deficits and debts. Public debt is expected to reach levels not seen in fifty years.

According to the Commission, the crisis has caused a sharp fall in potential growth. The Commission has revised its estimates, even for the pre-crisis period, raising the output gap for the euro area for 2007 from -0,2% to 2,5%, potential growth for the area would only be 0,9% per year on average from 2008 to 2010 instead of 2,1%. The structural public deficit of the area would have been 1,9% of GDP in 2007 and would reach 5,1% of GDP in 2010.

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According to some observers, this crisis has revealed many flaws in the Euro’s production. Some of them are as follows. A common monetary policy conceived with the European Central Bank confined to monetary stability (inflation dogma and prohibition of direct lending to states), the absence of common budgetary, economic or fiscal policy (on the contrary, deregulation and fiscal competition set the states against each other). And finally, the lack of specificity of the Eurozone in the general functioning of the European Union, although there is a Eurozone, there is no coordination between countries and no solidarity between states. What was highlighted about the Euro was that it allowed for low and uniform interest and exchange rates and this is precisely what asked the differences between the economies and encouraged some countries to go to a massive debt, creating bubbles (like estate agencies in Spain for example).

In the end, the attempt to converge the economies reinforced the divergence of the economies and favored the creation of two Europes: Northern and Southern.

What Will Happen to the European Union?

The consequences of the crisis and the difficult recovery of several countries in the region, steered the scholars to question the future of the common currency in Europe. During the crisis, the International Monetary Fund (IMF), the OECD and the Commission pushed governments to undertake large fiscal support programs. Now, these international institutions are pushing governments to undertake restrictive policies, while growth has not returned to the Eurozone.

Countries should return to their pre-crisis levels of public debt would lead to high interest rates that would crowd out investment and harm growth. But households want to hold a higher level of public debt because they need assets to finance their retirement and equities have proved too risky an investment. The sharp increase in public debt in the crisis has not been accompanied by a rise in interest rates and on the contrary, short rates are very low and long rates in line with the growth rate. A public deficit that supports growth, with interest rates as low as possible, cannot be accused of crowding out investment.

The IMF is asking developed countries to undertake restrictive policies of an additional 0.8 percentage points of GDP each year, without discussing the implications of this strategy on activity. If the multiplier of a generalized revival is 2, this means that growth will be reduced by 1.6 percentage points per year, public balances will not improve (since the fall in activity will reduce tax revenues), debt ratios will increase due to the economic slowdown. International organizations are calling for adjustment to be made by cutting public spending rather than raising taxes, without comparing the social utility of public spending and the spending of taxpayers hit by higher taxes, and without taking into account their impact on demand. They call for budgetary rules and independent fiscal policy committees. Yet the crisis has shown that fiscal policy cannot be rule-based and must be driven by a determined political power, which a committee of experts will never be.

From the end of 2008, financial markets started to speculate on the debts of European countries. Overall, the sharp rise in global debts and public deficits did not lead to increases in long-term interest rates, as the markets believed that money rates would remain low for a long time and that there was no risk of inflation or overheating. But the markets have realized that there is a flaw in the organization of the Eurozone. While governments of other developed countries cannot go bankrupt because they can always be financed by their central bank, the countries of the Eurozone have given this possibility. As a result, speculation was triggered in the most fragile Member States, namely Greece, Spain and Ireland, which had experienced strong growth before the crisis, but which had to change their growth model because of the crisis.

Financial markets risk completely paralyzing fiscal policy. In the past, when a country’s demand was too weak, the central bank lowered its interest as much as possible, the State increased its deficit, the low level of interest rates prevented the public debt from increasing too much, the mistrust of the markets resulted in a drop in the exchange rate, and therefore gains in competitiveness which helped to support activity. The risk is that later, a country from the Eurozone will no longer be able to increase its deficit, for fear that the markets will cause interest rates to rise, under the pretext of a risk premium. We cannot allow the financial markets to speculate on the bankruptcy of states. Therefore, the risk of state bankruptcy must be zero, the central bank must always be obliged to finance the states, even in the Eurozone. The European authorities and member countries were slow to react, not wanting to give the impression that member countries were entitled to automatic aid from their partners and wanting to punish Greece for not having respected the Pact. However, the European authorities indicated to the markets that they were providing unlimited support, first to Greece and then to all the countries under threat. In return, the threatened countries had to announce unprecedented budgetary austerity programs, which would condemn them to a sharp decline in activity and a long period of recession.

The Future of the Euro

Social protection expenditure since 2008 in the European Union reveals significant contrasts particularly East-West. The impact of the crisis and the changes in social policies are still visible. Indeed, the crisis made it possible to impose major cuts in social spending (like pensions and healthcare), which is the Commission’s permanent objective. But the risk here is to jeopardize the social cohesion and forcing households to save their pensions and healthcare system with the financial institutions responsible for the crisis.

According to Joseph Stiglitz, the single currency, if it remains in its current form, threatens the future of Europe, “the European project is too important to be sacrificed on the cross of the Euro”. Insofar, as the economy is intimately linked to politics, the Euro crisis can be explained above all by political blockages that prevent the progress that is indispensable for a more harmonious functioning of the economic and monetary union (to reform the structure of the Eurozone). For Joseph Stiglitz, the failures of the Eurozone are attributable to a combination of two factors. The first one is the failure of what he calls a ‘flawed ideology’, being the economic theories and the general conception of the economy that have guided economic policy choices so far. The second one is the lack of deep political solidarity between member countries, which has led to the paradoxical result that the victims are the guilty ones (example of Greece).

The Euro was founded on the promise of prosperity and political integration, and for Stiglitz neither of these goals has been achieved. The macroeconomic performance of the Eurozone has been particularly poor. Moreover, economic integration has gone much faster than political integration, which has led to a break-even point, in the framework of the monetary union of Europe that has not, by any means, eliminated its democratic deficit. In particular, he insists that this poor performance, due to the prolonged recession, not only weighs on future potential growth, but also leads to suffering and disappointment, especially for the younger generations, who are confronted with the full effects of the crisis. It is therefore not surprising to see the electoral progress of populist and sovereign parties that reject Europe (for example the illiberal turn that Hungary and Poland are taking).

Stiglitz’s ideas are followed by most of the politicians and economists. They criticized the rush to austerity being imposed on Greece, among others, suggesting it would be counterproductive by depressing growth and the competitive imbalances between Eurozone members would be impossible to overcome. They suggested the ultimate consequence of the crisis would be a much smaller eurozone with Germany at the center and countries such as Greece, Portugal, Italy and Ireland on the outside.

The 2008 crisis was inevitable, and this kind of crisis can happen again if no concrete measures are put in place to face them. Especially, with the sanitary crisis the world is facing today. But in the future to reduce the impact of such a crisis or to avoid it, will be the creation of a political integration within the European Union. Indeed, the European Union is suffering from a democratic deficit, and to reduce it could help to avoid any crisis in the future. This political integration could also slow down the wave of populism that Europe is facing.