CHAPTER 2: Unsteady foundations |
The roots of the crisis
25. The initial cause of the crisis in the euro
area may have been the global banking crisis in 2008, but the
severity with which it impacted upon the euro area exposed shortcomings
in the existing architecture of the Economic and Monetary Union
(EMU). We consider first the role the financial sector played
in creating the crisis before looking at the structural problems
of the EMU.
THE TRIGGER - THE FINANCIAL SECTOR
26. Mr Mark Cliffe, Chief Economist at ING
Group, drew our attention to the clear connection between Member
States' current fiscal difficulties and the problems of the financial
sector in the banking crisis.
The root cause was that "the financial crisis has forced
European governments to step in to support their banking systems".
Ireland's current debt crisis, for example, is a direct result
of its government's decision to offer a blanket guarantee to depositors.
Many other countries also bailed out or supported their banks,
escalating the level of public debt across Europe dramatically.
In some cases this led to concerns that countries would not be
able to service their debt, which in turn would then result in
losses for banks holding the debt. Dr Marco Annunziata, Chief
Economist at Unicredit Group, expanded on how this threatens the
EU as a whole:
"Part of the concern that we have about the
current situation in Ireland, Greece, and Portugal, is that the
sovereign debt issued by these countries is being held in significant
amounts by banks in other member countriesin the Eurozone
... but also outside the Eurozone, as in the UK. This implies
that shocks and instability in one member country can no longer
be isolated and contained to that country; they spill over".
27. Dr Daniel Gros, Director of Centre for
European Policy Studies, argued that this was a key issue and
noted that "many people ... did not put enough emphasis on
strengthening the banking system".
He would "trade the entire van Rompuy package on economic
governance against a couple of things on the banking side".
28. Mr Costello noted that the Commission
was working to create "a competitive banking system, one
which avoids a recurrence of where, in countries such as Ireland,
their share of the banking system goes beyond their capacity to
Supporting this goal was its work on a financial package of supervisory
regulations and bodies to control the behaviour of the banking
sector. Financial supervision lies outside the remit of this inquiry.
We note, however, that improvement and reform of financial supervision
will be a vital part of measures to support the euro area in the
long-term, for example the need to remedy the under-capitalisation
of certain European banks. The connection between financial supervision
and the wider economic governance framework covered in this report
will take place through the European Systemic Risk Board (ESRB).
We consider the ESRB in more detail in chapter 4.
29. The interconnection of the sovereign debt
and banking sectors was one of the principal elements that contributed
to the current crisis. Recent events have demonstrated the debilitating
effect on public finances of transferring private debt to the
public sector. Mechanisms must be put in place to control the
behaviour of banks and to ensure that the public sector does not
end up carrying the cost of failing banks. These must be effective.
We also note the risk of a vicious circle whereby a sovereign
debt crisis puts pressure on banks, including UK banks.
A FRAGILE HALFWAY HOUSE
30. While the banking crisis may have triggered
the current crisis in the euro area, our witnesses pointed to
a series of structural failings in the construction of the EMU
which explain the severity with which euro area countries were
affected. The first is an asymmetry at the heart of the EMU; that
while monetary policy is centralised, fiscal and supply-side
policies are left to the discretion of Member States. This can
mean that the collective decisions of euro area countries do not
necessarily add up to a coherent whole. Professor Goodhart
told us that "the Eurozone is a difficult and fragile halfway
house because it combines monetary centralism while leaving fiscal
and indeed wider political issues to the individual nation states".
Since political and fiscal centralisation had not followed monetary
union, "the current crisis that we see is a natural, indeed
almost inevitable, result".
31. In unitary states (a nation governed as a
single unit where all sovereignty lies with the central government,
for example Britain), as in federations (where the central government
shares sovereignty with sub-national units, for example the USA),
the central government typically has a large budget and fiscal
policy acts in tandem with monetary policy to maintain macroeconomic
stability. Typically, the central budget takes the strain in a
downturn and budget deficits increase because tax revenues fall
and public expenditure rises. A central government budget can
also redress regional imbalances within a country: if a region
encounters difficulties, it will raise less from national tax
instruments and generally expect an increased share of national
public spending. In the EU, however, the quasi-federal budget
is very small as a proportion of GDP (1%, compared with the some
20% or more found in many federations), must always balance (it
cannot therefore go into deficit) and is expressed in predominantly
multi-annual spending programmes with little flexibility. Consequently
it is unable to play a significant role either in automatic stabilisation
or in redressing macroeconomic imbalances.
32. Other witnesses described further problems
flowing from the very limited form of fiscal union in the euro
area. Dr Mayer argued that a central bank alone could not
ensure stability in a financial crisisit needed help from
fiscal authorities. A collective fiscal response to crisis can
only be achieved by coordinated action by all the members of the
euro area. Such coordination is very difficult to achieve, especially
when rapid action is required.
Professor Willem Buiter, Chief Economist at Citigroup, suggested
that by giving up monetary autonomy Member States had lost the
ability to provide a lender of last resort able to supply liquidity
to its financial sector. Traditionally, this function was assigned
to national central banks at the discretion of the national government,
but the power of Member States to demand such lending has gone
because the European Central Bank is far more independent of political
authorities than any national central bank could hope to be. He
suggested that this meant that "no national government, with
the possible exception of Germany ... will ever be able to compel
the ECB very easily into providing the liquidity that it needs
to prevent a potential default".
33. In short, there is an asymmetry in the EMU
between a powerful and centralised monetary policy and a fragmented
and inadequately coordinated fiscal policy.
A PROBLEM OF COMPETITIVENESS
34. Other witnesses pointed to a different problem:
a growing disparity in competitiveness between different states
within the euro area. Dr Dadush, for example, told us that
"The fundamental cause of the Eurozone crisis ... is the
build-up over a decade of large macroeconomic imbalances and the
loss of competitiveness of stricken countries".
As Mr Leandro explained, "competitiveness imbalance
means, for example, big divergences in current account balances"
where Member States were "importing more than they were exporting
and were losing competitiveness".
35. There are two main reasons for these macroeconomic
imbalances. Firstly, a single currency has meant a single base
interest rate across the euro area. This in turn permits private
credit to be available in relatively inflation-prone economies
like Greece at the same nominal interest rate as much stronger
economies such as Germany where inflation rates are lower. This
leads to credit bubbles and unsustainable levels of private borrowing.
Dr Dadush explained: "the competitiveness loss was made
worse ... by a common monetary policy that was too loose for fast-growing
and/or higher inflation countries in the European periphery and
too tight for Germany and other countries in the European core".
36. Secondly, when Member States became relatively
less competitive "euro membership prevented these countries
from devaluing their currencies to regain competitiveness".
The European Trade Union Confederation (ETUC) described the other
side of the equation, telling us that when Germany started a process
of competitive disinflation (i.e. deliberately holding wage increases
below the rate of inflation), "whereas in the past, the gains
... were simply neutralised by an appreciation of the national
currency ... this was no longer the case under monetary union".
37. Dr Buiter felt that there was nothing
inherently worrying about some countries remaining uncompetitive
in the sense of having lower productivity than their peers. The
result would be "they will simply be poorer".
For others such as Open Europe, these "chronic gaps in competitiveness"
are the "most critical shortcoming of the euro area",
while Dr Annunziata stated that in addition to stricter fiscal
rules "it is equally important to foster convergence in competitiveness".
Professor Jean Pisani-Ferry, Director of Bruegel (a European
think tank), explained bluntly: "a number of countries in
the euro area have lost competitiveness in a major way ... These
countries will have to regain competitiveness. That is an imperative
for everyone. If they do not, they will be permanently in a situation
of high unemployment and struggling with growth. That is a dangerous
situation for everyone".
It would mean a sizeable number of countries depressing demand
in the euro area as a whole.
38. These structural problems were exacerbated
by a failure by the markets, and Member States themselves, to
understand the construction of the euro area. The markets treated
all Member States within the euro as if they posed the same risk,
which given Germany's economic strength meant that the spread
on sovereign bonds was extremely limited. The result, as Professor Goodhart
noted, was that until late 2009 "the general belief was that
there was really no sovereign risk in Eurozone countries".
The markets assumed that the construction of the euro area would
lead to responsible fiscal behaviour (through the Stability and
Growth Pact) and a bail-out for any Member States which did encounter
As Professor Buiter explained, "the markets got it radically
wrong in the run-up to the financial crisis ... they underpriced
credit risks generally and they undoubtedly will get it wrong
economies were able to access market funding far too cheaply,
and without a spread in sovereign bond rates the market did not
play its usual role in restraining irresponsible government behaviour.
We consider the role of the market as a means of disciplining
governments in chapter 3.
Looking to the Future
39. The two structural problems we identify above
(paragraphs 30-37) remain sources of destabilising pressures in
the euro area. This led some witnesses to ask "whether monetary
union among sovereign states requires some sort of fiscal union".
The term "fiscal union" is a generic term, and there
have been a range of suggestions as to what such a union might
entail. The suggestions range from a limited fiscal union where
a euro area institution coordinated individual nations' fiscal
policies, to a full fiscal union, which Dr Annunziata described
as "a central authority in Brussels [that] would to a large
extent run fiscal policy for the whole of the euro area, in a
system similar to that of the US".
This would involve cross-border transfers of tax-payers money
to pay for public services, but would also create a system of
stabilisation that would mitigate regional imbalances.
40. Many witnesses felt that this would be beneficial;
Dr Annunziata called "full fiscal integration"
the "simplest solution",
while Mr Cliffe talked of the "fiscal transfers and
burden sharing that would make it [the euro area] sustainable
in the long run".
Professor Goodhart said that "it would be a lot easier
for all, in terms of the operation of the system, if the centralised
monetary system was coordinated with a much more centralised fiscal
ETUC went even further, stating that "you need a European
fiscal policy, or as you call it a closer fiscal union, to get
the single currency to survive".
Mr Mats Persson of Open Europe agreed and stated that to
overcome the difference in competitiveness "you really need
a full-blown fiscal union with continuous transfers".
41. Although it seems that, from an economic
point of view, full fiscal union might be desirable, our witnesses
were strongly of the view that this would be politically impossible
to achieve at present, or at any time in the near future.
42. An intermediate form of fiscal union might
be to enhance the scope for collective borrowing by the euro area,
so as to make it easier for fiscally vulnerable euro area countries
to finance their deficits at an acceptable cost. This would imply
accepting joint liability for a certain level of sovereign borrowing.
Recent proposals for jointly issued eurobonds move in this direction.
In practice, this is what the EFSF offers as a short-term expedient,
but proposals to issue eurobonds that could be used to finance
sovereign debt of all Member States have met considerable resistance.
We consider these proposals further in chapter 5, but conclude
that they are likely to represent a greater degree of fiscal integration
than Member States are willing to accept at present.
A FEASIBLE ALTERNATIVE
43. It seems clear that a full fiscal union is
unfeasible, and a more limited version unlikely. The direction
taken by the Commission and the governments of the EU since the
crisis has therefore been to propose new mechanisms, and to strengthen
existing ones, to coordinate economic policies more closely to
lessen the difficulties created by the absence of a fiscal union
and a build-up of competitiveness imbalances between Member States.
Mr Mark Hoban MP, Financial Secretary at HM Treasury,
illustrated this when he stated: "it is clear from this crisis
that there needs to be much greater coordination between states
in the Eurozone than there has been in the past".
44. We heard scepticism from some witnesses that
mere coordination, as opposed to union, would be sufficient. Mr Persson,
for example, told us that "fiscal coordination ... might
help a little bit, but it can only take you so far",
while Professor Christos Gortsos, Panteion University of
Athens, felt that "in a long-term perspective ... the only
viable solution" is a "single fiscal policy ... which
could efficiently support the monetary unification".
Others, however, were supportive. Ms Barysch felt that "a
monetary union can work if the constituent nations agree on very
close economic policy coordination and the enforcement of very
Dr Annunziata agreed
and endorsed the direction taken by the Commission and by the
van Rompuy taskforce.
45. Overall, we felt that witnesses were uncertain
as to whether closer fiscal coordination by Member States would
be sufficient to overcome destabilising pressures within the EMU.
Mr Hoban perhaps summed up the balance of the views when
he stated that the Commission's proposal created "the right
framework", but that "it depends how Member States react
to this". We
discuss the Commission's proposals for greater economic cooperation
in relation to fiscal policy and competitiveness imbalances in
detail in chapters 3 and 4.
46. There are flaws in the concept and design
of the euro area, caused by an asymmetry between a centralised
monetary policy and decentralised fiscal and supply-side policies,
and by a build-up of competitiveness imbalances between Member
States. The simplest solution, a greater centralisation of fiscal
policy leading to a full fiscal union, is politically unfeasible
at the present time. A more limited form of fiscal union consisting
of collective borrowing by the euro area is perhaps more plausible.
Given that there has been no general agreement on this issue among
Member States, however, it is unlikely to be more than an incomplete
alternative in the near future. The package put forward by the
Commission and the governments of EU Member States (through the
Van Rompuy task force) opts for a greater coordination of fiscal
and economic policies among euro area countries to overcome these
flaws. If these proposals work well, they should make it easier
for Member States of the EU, and particularly the euro area, to
arrive at a collective fiscal stance that is compatible with a
single monetary policy.
47. While the success or otherwise of these proposals
will determine whether the euro area is able to survive in the
longer term, some commentators have questioned whether it will
be able to survive intact the immediate challenges of the financial
crisis. Mr Cliffe informed us that while "the political
will to sustain monetary union is still very strong",
"the markets now put a significantly higher probability on
at least some exits from monetary union over the next few years".
48. We heard two scenarios where a Member State
in financial difficulties might leave. On the one hand a state
could feel it would be to its economic advantage to leave, regaining
the ability to set its own interest and exchange rates. Alternatively,
it might be asked to impose "potentially politically intolerable
fiscal austerity measures" to remain in the euro.
49. Witnesses suggested that a voluntary exit
by a country in difficulties was highly unlikely since countries
were better off in the euro than out.
They noted, however, that the fiscally strong countries in the
euro area might leave, splitting the euro area in two. Professor Buiter
put this view: "The only real risk for the euro area falling
apart is not the fiscally weak and uncompetitive countries leaving;
they'd be mad. It is the fiscally strong and competitive countries
leaving". Mr Cliffe
and Mr Persson told us that it had been suggested that the
Germans, perhaps along with some other core euro area members,
might wish to leave at some point.
This view, however, was dismissed by Ms Barysch: "when the
initial debate [in Germany] has calmed down a bit, you will find
a nation that remains very much committed to the European project
because it doesn't see an alternative".
50. Sir Martin Jacomb, Chairman of the Canary
Wharf Group, argued that the euro area would survive simply because
"the political imperatives to keep it going are too great".
Professor Buiter concluded that he was "optimistic about
the survival of the enterprise [the euro]", albeit "not
about the elegance with which that survival will be achieved".
51. It is important to recognise that withdrawal
from the euro area would not be an easy exercise. It should not
be confused with leaving the exchange rate mechanism (as the UK
and others did in the early 1990s), because of both practical
difficulties involved in recreating a national currency and legal
constraints. Professor Louis stressed to us that "the
monetary union has been conceived as irreversible": there
is no formal, legal process for a country to either leave the
euro, or to be expelled from the euro.
According to Phoebus Athanassiou, Legal Counsel of the European
Central Bank, "a Member State's exit from EMU, without a
parallel withdrawal from the EU, would be legally inconceivable".
52. The Minister refused to speculate on whether
the euro area would survive in its current form, simply noting
that "there is no mechanism for countries to leave the euro",
and adding that "it would be quite a big step for that to
53. Professor Goodhart stated that "the
costs, political as well as economic, to a country voluntarily
leaving the euro are huge".
Mr Cliffe told us that any benefits for a country leaving
the euro "would come along with considerable costs"
and "there would be severe transitional costs for any members
leaving the monetary union".
In a paper for the ING Group, EMU Break-up: Quantifying the
Unthinkable he concludes that "the numbers are debatable,
but the impact would undoubtedly be traumatic". The trauma
would be most severe for those countries leaving the Euro, but
other countries in the euro area and the wider EU would also suffer,
and the report finishes with a warning that "this is perhaps
something that policy-makers may care to reflect upon when they
blithely talk of exit from EMU as being a policy option".
It is perhaps worth noting that those countries currently in difficulties
make up only a small proportion of the euro area's combined gross
domestic product (see Appendix 6).
54. We believe that the political imperatives
holding the euro area together are strong, and we do not think
it is likely that any country, whether fiscally weak or strong,
will try to leave voluntarily. We do, however, recognise that
it is now conceivable that a country could be forced to leave
the euro, or that the euro area could separate into two parts.
55. Any break-up of the euro area would not
only be economically and politically costly for those Member States
leaving the euro, but would have a damaging impact on all members
of the euro area and the wider EU, not least the UK.
Governance within the euro area
56. The role of the Eurogroup (a body composed
of finance ministers of the Member States of the euro area), has
grown significantly since its formation in 1998. It came into
existence as an informal body, although it has since acquired
formal recognition in the Lisbon treaty.
Its primary role has been to agree common positions in relation
to ECOFIN decisions
that pertain solely to the euro area. However, it also offers
a forum in which euro area finance ministers could review economic
conditions and debate policy choices.
57. There have been suggestions that the Eurogroup
might be given a more official role among the EU institutions.
We wondered whether this might create a risk of marginalisation
for those Member States who are not in the euro. The Eurogroup,
since it contains a majority of Member States of the EU, can effectively
decide issues pertaining to the whole EU before they can be discussed
at ECOFIN. This perception was strengthened by President Sarkozy's
calls for a unified economic government of the Eurogroup,
and by recent agreement on a "Pact for the Euro" (see
58. Professor Louis reminded us that Mr Blair
had opposed the idea of strengthening the formal role of the Eurogroup
as it would have been "a farce" to have a decision-making
body without the presence of the UK. The members of the Eurogroup
at the time, meanwhile, saw this move as potentially "too
divisive". Mr Zuleeg
thought however that, since the Eurogroup was now in the Treaties,
"it has an official role ... it has responsibility for coordinating
59. Ms Barysch also told us that the Eurogroup
already exercised a leadership role. She noted, though, that Germany
was reluctant to "institutionalise" the Eurogroup since
it was dominated by southern European countries, in contrast to
the EU 27 where their presence was balanced by the more "liberal
and fiscally responsible" northern and eastern European countries.
The Government were clear that "ECOFIN Council should retain
its primary role as the forum for discussion of EU macroeconomic
and fiscal policies". They would not, therefore, "support
the creation of new euro area institutions" that could undermine
60. We did not receive compelling evidence
to suggest that the Eurogroup needed a more formal role and position.
Such a move could have implications for the UK and for the position
of ECOFIN as the ultimate decision-making body on financial and
economic matters. Recent decisions by the Eurogroup to adopt a
"Pact for the Euro" have brought these implications
into sharp relief.
Speaking with a single voice
61. While the euro area is a single monetary
union, a multiplicity of voices have spoken on its behalf during
the current crisis.
On occasion, different participants have given conflicting comments
or made remarks on behalf of one euro area country without ensuring
that they had the support of other Member States. This has had
unfortunate results at times. As an example, Mr Leandro,
speaking to us about private sector involvement in sovereign bonds
admitted that "there have been a lot of misunderstandings
about this ... Some say this is one of the reasons we are seeing
the turmoil in the markets".
Professor Buiter emphasised this point: "there is a
huge communication deficit between the markets and European political
leaders, especially but not only in Germany" and argued that
politicians "do not communicate well with markets".
62. Mr de la Chapelle Bizot put the need
succinctly: "It will be really important to show the rest
of the world unity at the level of the European Union. If the
markets ... could consider that there is no unity, no impetus,
no consensus to go forward and tackle the financial difficulty
inside the European Union or the Eurozone, we will, together,
face real difficulties".
63. There is a clear need for the euro area
to speak with one voice in crisis situations. It is essential
that it improves the speed and clarity with which it communicates
with the markets.
23 Q 62 Back
Q 53 Back
Q 127 Back
Q 170 Back
Q 171 Back
Q 385 Back
We have covered some of this material in a previous report however.
See European Union Committee, 14th Report (2008-09): The future
of EU financial regulation and supervision (HL Paper 106) Back
See paragraphs 171-177 Back
Policies affecting, inter alia, the labour market, social
protection, research and development, and skills. Back
Q 82 Back
Q 83. See also, Q 486 (Professor Buiter), EGE 6 (Professor Gortsos) Back
Q 130 Back
Q 485 Back
EGE 18 Back
Q 244 Back
EGE 18 Back
EGE 7 (Open Europe). See also, EGE 13 (Sir Martin Jacomb) Back
EGE 2 Back
Q 500. See also Q 106 (Dr Schelkle) Back
EGE 7 Back
EGE 9 Back
Q 284. See also, Q 244 (Mr Leandro) Back
Q 86 Back
To date, of course, the euro area has indeed provided financing
for any Member State in financial difficulties. Back
Q 495 Back
See paragraphs 79-82 Back
Q 452 Back
Q 127 Back
Q 127 Back
Q 64 Back
Q 98 Back
EGE 2 Back
Q 430 Back
For example, QQ 489 (Professor Buiter), 98 (Professor Goodhart),
294 (Mr de la Chapelle Bizot) Back
See paragraphs 211-217. Back
Q 520 Back
Q 430 Back
EGE 6 Back
Q 452 Back
Q 128 Back
EGE 9 Back
Q 523 Back
Q 64 Back
Q 51 Back
Q 51 (Mr Cliffe) Back
QQ 55 (Mr Cliffe), 132 (Dr Mayer), 134 (Dr Annunziata) Back
Q 494 Back
QQ 51, 411 Back
Q 462 Back
Q 146. See also Q 63 (Mr Cliffe) Back
Q 502 Back
Q 350 Back
Athanassiou P, Withdrawal and expulsion from the EU and EMU:
some reflections (2009), ECB Legal Working Papers Series No.
Q 506 Back
Q 99. See also QQ 404 (Professor Copeland), 409 (Mr Persson) Back
Q 51. Back
ING, EMU Break-up: Quantifying the Unthinkable (2010),
p 16 Back
Q 336 (Mr Zuleeg) Back
The Economic and Financial Affairs Council. It is composed of
the finance ministers of Member States. Back
See, for example, "Czechs reject Sarkozy's Eurogroup presidency
plans", EurActiv.com (24 October 2008) Back
Q 348 Back
Q 336 Back
Q 459 Back
EGE 14 Back
Q 456 Back
See paragraphs 199-200 in Chapter 5 for further explanation of
this issue. Back
Q 261 Back
Q 495 Back
Q 304 Back