7811043664_ab5cf4c0e3_oSince its outbreak in 2009, the European sovereign debt crisis has unveiled the main deficiencies of the Eurozone system. While it was conceived as a means to strengthen the economies of its Member States and their capacity to face severe economic downturns, the monetary union has proved to be a key factor in exacerbating the seriousness of the effects of the crisis. During the last years, this paradox has raised concerns on the limits of the Euro system, stimulating the debate on the possible solutions to improve its strength and efficiency.

The outbreak of the crisis and the creation of new stabilization mechanisms

 To understand why the efforts made in the Eurozone have not produced the expected effects up until now, we need to analyze the main phases of the sovereign debt crisis and the measures taken to recover from the downturn.

The European debt crisis burst at the end of 2009 when the Eurozone states showed to be unable to bailout their national banks (which frequently owned a large part of national debts) and to repay (or to refinance) their government debts. This was a consequence of the Great Recession, which had led to high government structural deficits and accelerating debt levels in Europe during the previous years. In particular, fear that Eurozone countries would not have repaid their debts spread after Greece admitted to have masked its true debt levels and budget deficit in order to accomplish with Maastricht’s parameters.

Anxiety about excessive national debts pushed lenders to demand soaring interest rates when purchasing bonds of countries with high debt levels and current account deficits. This hindered the capacity of governments to finance further budget deficits and service existing debts, inasmuch as economic growth rates were decreasing. Even though sovereign debts were rising only in a few Eurozone countries, there was a widespread and mistaken perception that all the Euro area had been affected severely by the crisis. This misrepresentation fostered contagion of other European countries, thus giving birth to a self-fulfilling and self-reproducing crisis.

The threat of default in the Eurozone led to the downgrading of government debts of its Member States. In the meantime, four Eurozone states were rescued through a joint sovereign bailout program, carried out by the International Monetary Fund together with the European Commission and the European Central Bank. The activation of bailout programs depended on the implementation of a package of structural reforms aimed at strengthening the fiscal system, privatizing public assets and hoard funds for future bank recapitalization programs. In this scenario, new European supervising institutions, adjustment mechanism and cooperation fora were created. Specifically, some important projects were implemented in order to rebuild and preserve the economic and financial stability of the Eurozone. In June 2010, the Euro area Member States created the European Financial Stability Facility (EFSF) to “safeguard financial stability in Europe by providing financial assistance” to the Eurozone. It was established as a temporary crisis resolution mechanism aimed at offering financial assistance to the Euro area countries, provided they committed to certain reform plans. The EFSF was conceived to issue bonds and other debt instruments on the market in order to raise funds to recapitalise banks, to provide loans to Eurozone countries which asked for financial aid or to buy sovereign debt. Then, Member States began to consider the possibility of creating a banking union in order to homogenize Eurozone’s banking law and to further prevent shocks. At the same time the EU countries created the European Financial Stabilisation Mechanism, which allowed the European Commission to raise funds in the capital market on behalf of the EU, in order to provide financial assistance to Member States faced with exceptional circumstances beyond their control.

In October 2012, a new permanent crisis mechanism, the European Stability Mechanism (ESM), replaced the EFSF. The ESM was designed as a permanent crisis resolution mechanism. This new intergovernmental financial institution was charged with protecting the solvency of Euro area member states experiencing temporary financing difficulties by employing tools such as granting loans or purchasing sovereign debt.

Finally, EU countries established the European System of Financial Supervision (ESFS) based on two pillars. The first one concerned macroprudential supervision functions, exercised by the European Systemic Risk Board (ESRB), under the responsibility of the European Central Bank. The aim was to contribute to the prevention and mitigation of systemic risks to financial stability and to ensure a sustainable economic growth in the European Union. The second pillar regarded microprudential supervision functions, shared by the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), the European Insurance and Occupational Pensions Authority (EIOPA).

The evolution of the ECB

Not only did the Member States create new stabilizers after the outbreak of the crisis, but they also asked for a more direct intervention of the ECB in order to contrast the downturn. These pressures have brought to considerable transformations in the role of the ECB during the last years. Its evolutionary path can be divided mainly in four phases.

At first, the ECB was charged exclusively with providing technical support with regards to the bailout programs. Its hesitation towards active participation in the recovery program was tightly connected to its will to respect article 123 TFUE, which stated that “Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”. However, the seriousness of the crisis made the recovery hard to achieve and pushed the EU Member States to approve a bilateral loan program.

At the same time, they asked the ECB for a more direct participation in the bailout programs. Following this request, the ECB approved the Securities Market Program (SMP), a strategy that focused on direct interventions led by the Euro system in public and private debt securities markets in the euro area, aimed at ensuring depth and liquidity in those market segments that were dysfunctional. The purpose was to restore monetary equilibrium and price stability in the EU. This program raised concerns among many EU countries, as it seemed to contrast with the prohibition of monetary financing of budget deficits stated in the above-mentioned article 123 TFUE. However, it was highlighted that purchase of these bonds was permitted when recurring to the market and under the condition that the operation would not be implemented in order to elude the above-mentioned ban. In fact, Article 18 ESCB (Open market and credit operations) states that “1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may: operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals; conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral. 2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.” Therefore, the SMP could not be considered as a measure to finance Member States’ debts. Indeed, it was program to lower interest rates and support internal market in order to sustain the level of liquidity in the Eurozone and to foster money flows between European banks.

In spite of the efforts of International institutions and EU countries, recovering from the sovereign debt crisis proved to be an unexpected extremely hard challenge. This pushed the ECB to announce free unlimited support for all Eurozone countries involved in the bailout program, in September 2012. This objective was achieved through the implementation of Outright Monetary Transactions (OMT), a new model of intervention that allowed the ECB to buy government-issued bonds in order to sustain the level of liquidity in the Euro area. Even though the objective of this new program appeared to be the same of the SMP, there were some important differences between the two measures. OMT was implemented by the ECB using ESM and EFSF funds and the activation of the mechanism was subordinated to the request of financial assistance of a Eurozone country. This last had to fulfil some conditions in order to benefit from the OMT, such as having received financial sovereign support through the participation in an EFSF and ESM’s bailout program.

The last phase of ECB’s evolution process opened on January, 22 th 2015, when the Governing Council announced an expanded asset purchase program that would have included bonds issued by governments of the Euro area, agencies and European institutions, acquired in the secondary market against central bank money. This measure was aimed at addressing the risks of a too prolonged period of low inflation, which has interested the Eurozone up until now (in fact actual and expected inflation in the euro area had drifted towards their historical lows), in order to fulfil ECB’s price stability mandate. How this program will help the Eurozone’s recovery is easy to understand: asset purchases, which include government bonds, will provide monetary liquidity in the Euro area, thus lowering interest rates and easing financial conditions. This scenario will render access to loans cheaper for firms and households, a circumstance that will support investment and consumption, and ultimately stimulate inflation rates’ growth. The differences between the OMT and the new system are relevant. Through the OMT, the ECB committed to buy unlimited amounts of sovereign bonds in order to help countries that required financial assistance. In this framework, not only did the ECB act as a lender of last resort but it also bound the activation of the OMT mechanism to the fulfilment of some conditions. In particular, States which benefit from the ECB’s action would have need to implement fiscal austerity and structural reforms. Instead, the new measures decided in January 2015 are quantitative easing operations through which the ECB will inject liquidity into the monetary system in order to directly stimulate the economic activity.

Unfulfilled expectations and new awareness 

Heretofore, the Eurozone has proved to be unable to recover completely from the crisis, which has affected the area since 2010. Therein lies the paradox. When the Eurozone was conceived, there was a widespread consensus that the economies of the Member States would have benefit from the monetary union. In particular, this system was expected to help Member States to create economic stability while strengthening their capacity to face downturns and crisis. Clearly, the opposite has occurred. The crisis had severe repercussions on the EU stability, fuelling political crisis, the rise of extremist parties, unemployment and unrests. Since monetary union did not fulfil the expectation, disillusion towards the effectiveness of the monetary union spread throughout the markets, the continent and its citizens, inflaming the debate on the structural limits of the Eurozone system.

There are evidences that the monetary union has ultimately worsened the effects of the crisis on the Eurozone. Indeed, it is easy to understand why the financial measures taken to contrast the crisis have not been effective and why the monetary union has produced perverse effects on the Eurozone.

Concerning the measures elaborated to foster the recovery, the primary cause of their ineffectiveness lies in the asymmetry of the adjustment system. This asymmetry is a legacy of the 2010 sovereign debt crisis, which split the Eurozone into creditor and debtor nations. Debtors were countries, usually concentrated in peripheral areas of the Eurozone, spending more than they were producing. This created budget deficits, which were financed by creditors, that is to say Member States registering surplus in their current accounts. Increasing divergence in the positions of EU countries was one of the elements that have frustrated the recovery from the crisis, up until now. The reason lies in the fact that, since 2010, creditor Member States have imposed austerity to the debtor nations in order to reduce their deficits and restore economic equilibrium. However, creditors have not implemented the same opposite economic measures in order to adjust their excessive surplus (which in the long term can be as harmful as excessive deficit). No increase of expenditure was carried out by creditors, which continued to save. This produced two perverse effects: on the one hand, it gave birth to a saving paradox. If a community of individuals starts to save excessively this affects income flows of the community as a whole. In fact, saving more corresponds to spending less, which means less income for the other members of the community who, at the same time, will be pushed to similarly save more and spend less. Therefore, excessive saving will hurt individual and national income. When reproducing in a system such as the Eurozone, this negative spiral (that has been at the core of the problem) affects the economic cycle of the region as a whole. There has been an ill-concealed unwillingness to recognize this problem. EU countries have only focused on structural reforms, which certainly are important but their effectiveness hinges on the implementation of a symmetrical adjustment mechanism (i.e. austerity for debtors and higher expenditure for creditors).

On the other hand, these circumstances have affected the capacity of the debtors to pay back their debts. Therefore, the ultimate objective, namely reducing debt burden, was not achieved. This result is simple to explain. The above-mentioned ill-conceived macroeconomic policies, that led everybody to save at the same time, further lowered the growth rate and pushed the Eurozone into deflation. With deflation spreading across the Eurozone, the debt-to-GDP ratio (e.g. the ratio between a country’s government debt and its gross domestic product) soared dramatically. In fact, considering this relation, increasing deflation made the denominator plunge, raising the debt burden. Hence, deflation has reduced the capacity of countries to service their debts, which, instead, has been soaring during the last years.

So austerity proved to be no panacea. On the contrary, many consider that it has ultimately worsened the economic situation of the EU due to the asymmetrical adjustment system. Some experts have highlighted that having debt burden become unsustainable the unique rational solution is to implement debt restructuring. This assertion is based on the consideration that if some debtors have been foolish in building up too much debt, there has also been foolish creditors which has financed the debtor countries. Creditors showed to be as reckless and blind as debtors so responsibility of the crisis is shared. Besides, moralistic tones conceiving surplus countries as good and deficit countries as bad have been very important in explaining why ill-conceived macroeconomic policies were implemented to contrast the crisis. In this scenario, debt restructuring could be the key to avoid default. The intuition is easy to understand. If creditors insist on having full repayment that states cannot afford, the risk of default increases. Default would mean no repayment at all. However, creditors can decide to maximize their own result through debt restructuring. Indeed, it may be very rational for the creditor to be forgiving and get a partial repayment instead of exposing to default risks.

Concerning the ineffectiveness of the monetary union vis-à-vis the sovereign debt crisis, it can be explained recurring to what Paul De Grauwe (professor of European Political Economy at LSE) calls the “design failure of the Eurozone”. When the project was conceived, the architects of the Eurozone were convinced that building a monetary union would have ensured stability in the EU: national booms and busts would have become Eurozone booms and busts. Optimism towards the project was at its highest level, when, suddenly disillusionment spread as soon as the monetary union failed to meet expectations of their supporters. In fact, despite the centralization of money, national booms and busts did not become a Eurozone phenomena. This was due to the incompleteness of the monetary union. The Euro system project was based on the creation of a single currency and of a European Central Bank, which would have decided on monetary policies to implement in the region. However, all the other macroeconomic policies was kept at a national level. Up until now, Member States continue to decide on taxation, subsides, wage, etc. creating divergent policies that stretch the bias between their economies. During the first decade of the monetary union, this incompleteness (which can be considered its primary limit) has prevented national booms and busts to become Eurozone phenomena.

A second limit concerns the lack of stabilizers in the Euro system. Before the creation of the monetary union, EU countries had a number of stabilizers at national level. After the creation of the Eurozone, leaders abolished these mechanisms without reproducing something similar at a Eurozone level. Indeed, only after the crisis some adjustment mechanisms (i.e. the EFSF, the ESM, etc.) have been created. The stabilizer that lacked the most was a Central Bank that could take the role of lender of last resort for the governments. Usually, central banks are ready to provide liquidity to governments when in trouble. This function was abolished when the monetary union was created through Article 123, which prevents the ECB to buy government bonds. So the ECB maintained its role of lender of last resort only vis-à-vis the banks but not vis-à-vis the governments.

A third limit regards the excessive independence of the ECB. After the creation of the Eurozone, Member States could no more guarantee bondholders that cash would have always been available, because money printing fell under the of the ECB. The fact that EU governments depend on the willing of the ECB to provide liquidity has rendered the monetary union fragile. In fact, EU government bonds are more exposed to market reactions and countries have no weapons against this. The result is that national governments are weakened vis-à-vis the financial markets, which can force countries into default. In fact, these last cannot control money printing due to the monetary union system, which makes this process depending exclusively on the ECB’s decisions. The same cannot be said while considering single countries that preserve the power to issue their own currency. In this case they cannot be forced, against their will, into default by financial markets as they can print money to guarantee bondholders.

How to redesign the Eurozone

 Bailout programs, stabilizers such as EFSF, ESM, ESBR, and the new approach of the ECB will probably help the Eurozone to soothe crisis’ symptoms in the mid term but what about the long run? Given that the ineffectiveness of the monetary union is due to structural défaillances, the ultimate solution is to rethink the design of the Eurozone. Otherwise, we can expect that should another downturn occur, the Eurozone would not be able to face it, as it has happened in 2010. Many experts addressed the question about how to redesign the Euro system. Some of them have pointed out that the future of the monetary union, and ultimately of the EU, hinges on the implementation of three essential reforms, which appears to be tightly interconnected.

Firstly, some important economists have urged the Eurozone members to rethink the role of the ECB, in particular with regard to its powers and level of independence. From the crisis, Member States have learnt that the Euro system needs a central bank charged with operating as a lender of last resort both for the banks and the governments. It is undeniable that the ECB has changed its approach towards government-issued bonds during the last years. The main examples of this new approach are the OMT program and the recent Quantitative Easing announcement. However, the current monetary union remains a system where the ECB can lead down governments, so it needs to be reformed. Concerning its relationship with Member States, it is true that the ECB structure has evolved considerably during the last years, becoming much more inclusive and accountable. Besides, this evolution has temporarily stabilized the situation. However, ECB still preserves its deep independence from the Member States. Indeed, Eurozone countries continue to depend on the goodwill of the ECB to provide liquidity.

These circumstances highlight that the Eurozone is based on the primacy of the ECB over governments. This configuration, in times of crisis, can lead to perverse effects and become unsustainable. The intuition is easy to explain: the ECB structure is characterized by a severe lack of democratic legitimacy. In fact, ECB’s staff is composed by unelected officials which are charged with deciding the monetary policy of the Eurozone. In times of crisis, states can be forced to be insolvent because of decisions taken by unelected officials, who have the power to save members but refuse to do so. These characteristics unveil that independence of the ECB cannot be absolute and should be reduced. This is true, especially in times of crisis, when, in order to ensure the efficiency of the Euro system, governments should prevail over the ECB. These considerations highlight the need for a second essential reform: the creation of a Eurozone government that cooperates with the ECB, sometimes prevailing over it. Concretely, this would mean moving toward a political union.

Finally, many experts have emphasized the needs for a deeper coordination of macroeconomic policies. This reform is tightly linked with the previous two. In fact, no deeper coordination of macroeconomic policies can be achieved without creating an elected body, functioning as a European government that can take decisions at a European level, cooperating with and even prevailing over the ECB. It is undeniable that, nowadays, the European commission has acquired the power to monitor macroeconomic imbalances and to stimulate countries’ reactions. However, this procedure is implemented in an asymmetric way. Indeed, current account imbalances are seen very differently, in the sense that deficit is sill demonized and considered more harmful than surplus. The result is that it is extremely more difficult to induce surplus countries to spend more than to force debtors to save. This has to do with a widespread view that portrays surplus countries as the most virtuous ones.


The monetary union appears to be the most challenging and ambitious project of the last century. Its weaknesses are clear and need to be addressed rapidly to avoid the collapse of the Euro system. Member States that continue to overlook this are like “a foolish man who built his house on sand”. Surely, what has been done up until now has stabilized the situation but it is only a temporary solution. This governance structure cannot be maintained indefinitely. At some point, deeper political union become essential to sustain the system, otherwise, this last will be rejected. To make monetary union effective we should achieve deeper coordination of the other macroeconomic policies. In order to fulfil this aim, it is necessary to limit the independence of the ECB and to create a common government, charged with cooperating with the central bank and elaborating the Eurozone macroeconomic policies. This objective could be achieved by creating a banking union and a fiscal union, which would obviously imply deepening the European integration process.


This article was inspired by the conference “The Recent Evolution of the European crisis and the Future of the Eurozone”, held by Professor Paul De Grauwe at Luiss Guido Carli (Rome) on April, 9th 2015

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