The Future of the Eurozone and U.S. Interests
Raymond J. Ahearn, Coordinator
Specialist in International Trade and Finance
James K. Jackson
Specialist in International Trade and Finance
Rebecca M. Nelson
Analyst in International Trade and Finance
Martin A. Weiss
Specialist in International Trade and Finance
January 10, 2011
Congressional Research Service
7-5700
www.crs.gov
R41411
CRS Report for Congress
P
repared for Members and Committees of Congress
The Future of the Eurozone and U.S. Interests
Summary
Seventeen of the European Union’s 27 member states share an economic and monetary union
(EMU) with the euro as a single currency. Based on a gross domestic product (GDP) and global
trade and investment shares comparable to the United States, these countries (collectively referred
to as the Eurozone) are a major player in the world economy and can affect U.S. economic and
political interests in significant ways. Given its economic and political heft, the evolution and
future direction of the Eurozone is of major interest to Congress, particularly committees with
oversight responsibilities for U.S. international economic and foreign policies.
Uncertainty about the future of the Eurozone grew in early 2010 as a result of the onset of a
sovereign debt crisis in Greece that spread to Ireland later in the year. These concerns, in turn,
took on added significance because the euro is considered a cornerstone of the European
integration process.
One important cause of the crisis stemmed from flaws in the architecture of the currency union,
including the fact that the EMU provides for a common central bank (the European Central Bank
or ECB), and thus a common monetary policy, but leaves fiscal policy up to the member
countries. Weak enforcement of fiscal discipline, over time, led to rising public debts,
contributing to the 2010 Eurozone debt crisis. The problems were compounded by rapid
expansion private sector debt in a number of countries, most notably Ireland.
In response, European leaders and institutions have adopted financial assistance packages for
Greece in May 2010 and for Ireland in November 2010, combined with proposals to reform the
currency union. These reforms center heavily on creation of a permanent liquidity facility
(European Stability Mechanism or ESM) and real economy measures involving austerity and
structural reforms to lower deficits and increase the competitiveness of the most highly indebted
Eurozone members. These reforms do not contemplate sovereign debt restructuring, a break-up of
the Eurozone, or movement towards a political or fiscal transfer union.
The reforms, if implemented, could strengthen the foundation of the Eurozone and bolster
confidence in the euro. Given that the currency union is largely a political undertaking and a
major symbol of European integration, European leaders may be expected to support reforms
which keep the currency union intact. Moreover, the proposals under consideration introduce
institutions and policies that did not exist prior to the crisis, and represent higher levels of
integration and commitment to strengthening the EMU.
At the same time, a number of factors could weaken or even perhaps undermine the sustainability
of the Eurozone. In the event of sovereign defaults by some members, public support in fiscally
sound Eurozone countries for resource transfers to highly-indebted countries could decline.
Shared responsibility for defaults could also lead to divisions among Eurozone members, causing
some members to reconsider the costs and benefits of membership. In addition, the fiscal
problems some Eurozone members face stem from economic imbalances that may be very
difficult to resolve without a shift in economic policies by its members, particularly Germany.
If the Eurozone survives largely in its current form or strengthens, the impact on U.S. interests is
likely to be minimal. However, if the Eurozone were to break-up in a way that undermines the
functioning of Europe’s single market or resurrects national divisions, the impact on U.S.
economic and political interests could be significant.
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Contents
Introduction ................................................................................................................................ 1
Background on the Economic and Monetary Union (EMU) ......................................................... 3
Origins, Rationale, and Economic Significance ..................................................................... 3
Key Provisions of the EMU .................................................................................................. 5
Design Challenges ................................................................................................................ 7
Economic Imbalances and Adjustment Mechanisms within the Eurozone .................................... 8
Imbalances within the Eurozone............................................................................................ 8
Adjustment Mechanisms ..................................................................................................... 11
Eurozone Crisis Measures and Reform Proposals ...................................................................... 13
Emergency Crisis Measures ................................................................................................ 13
Greece Package............................................................................................................. 14
European Financial Stability Mechanism....................................................................... 14
European Financial Stability Facility............................................................................. 15
Participation of the International Monetary Fund........................................................... 15
European Central Bank Response.................................................................................. 16
Ireland Package................................................................................................................... 16
Economic Governance Reforms .......................................................................................... 17
Fiscal Policy Reforms ................................................................................................... 17
Economic Growth Policies ............................................................................................ 18
Possible Scenarios for the Future of the Eurozone ..................................................................... 19
Scenario 1. The Eurozone Breaks Apart............................................................................... 19
Exit by One or More Southern European Countries ....................................................... 20
Exit by One or More Northern European Countries ....................................................... 20
Scenario 2. The Eurozone Survives ..................................................................................... 21
Scenario 3. The Eurozone Becomes More Integrated ........................................................... 22
Implications for U.S. Interests ................................................................................................... 23
Economic Implications........................................................................................................ 23
Political Implications .......................................................................................................... 24
Concluding Observations .......................................................................................................... 25
Figures
Figure 1. Economic Trends in the Eurozone .............................................................................. 10
Figure 2. Selected European Current Account Balances............................................................. 12
Tables
Table 1. Eurozone Emergency Crisis Measures.......................................................................... 14
Table 2. The EU/IMF Irish Loan ............................................................................................... 17
Table 3. Glossary of Terms........................................................................................................ 27
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Contacts
Author Contact Information ...................................................................................................... 27
Acknowledgments .................................................................................................................... 27
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Introduction
What has become known as the Eurozone crisis began in early 2010 when financial markets were
shaken by heightened concerns that the fiscal positions of a number of Eurozone countries,
beginning with Greece, were unsustainable.1 Fears that a possible Greek default could spread to
other Eurozone countries, particularly Ireland, Italy, Portugal and Spain, were exacerbated by
revelations of banking sector weaknesses and a delayed policy response from European leaders
and institutions. After extended negotiations, European leaders agreed in May 2010 to provide
funding for a joint euro area loan facility for Greece and a broader one for other euro area
countries should they require loans.2 Both loan packages were backstopped by various forms of
assistance from the U.S. Federal Reserve Board (FRB) and the International Monetary Fund
(IMF).3 And on November 28, 2010, European and IMF authorities announced a three-year, €85
bn ($112 billion) assistance package for Ireland. European policymakers concurrently have
focused on the need to address flaws in the architecture of the Economic and Monetary Union
(EMU) of the European Union (EU).4
Most observers of the Eurozone believe that reform of the currency union is needed in order to
bolster the euro and avoid another fiscal crisis triggered by public debt and government deficits.
How the members of the Eurozone address this overriding challenge to bolster the viability and
stability of the currency union, in turn, has added significance. Unlike in countries such as
Argentina or Mexico, where currency crises did not bring into question the existence or survival
of the state, the euro bears weight in terms of Europe’s political aspirations for an “ever closer
1 For elaboration and analysis of the Greek debt crisis, see CRS Report R41167, Greece’s Debt Crisis: Overview,
Policy Responses, and Implications, coordinated by Rebecca M. Nelson.
2 Germany was widely criticized, including by U.S. officials, for waiting several months after the onset of the Greek
crisis in February 2010 before agreeing to loan facilities for Greece and other Eurozone member states. German
reluctance is thought to have stemmed primarily from strong domestic opposition to the proposed relief packages.
Many Germans consider Greece’s problems to be a consequence of Greek government profligacy and, as such, see
Greece as a burden on the German taxpayer. In light of this opposition, German Chancellor Merkel insisted that the
Greek government commit to significant austerity measures before giving her support to a European assistance
package. Nevertheless, the significant German public opposition to assisting Greece suggests that the German
government could have a difficult time winning support for future monetary transfers to other Eurozone countries. This
could present a significant challenge as European leaders engage in ongoing efforts to reform the architecture of the
currency union, as well as shore up the banking sector.
3 The United States is the largest financial contributor to the IMF, and some Members of Congress have expressed
reservations about the IMF loan to Greece. In response to the IMF loan to Greece, Congress included provisions in the
financial regulatory legislation (P.L. 111-203) to protect IMF resources. For discussion and analysis of the role of the
International Monetary Fund, see CRS Report R41239, Frequently Asked Questions about IMF Involvement in the
Eurozone Debt Crisis, coordinated by Rebecca M. Nelson.
4 A total of 17 states (Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Malta, Netherlands, Portugal, Slovakia, Spain, and Slovenia) of the 27-member European Union (EU)
participate in an economic and monetary union (EMU) with the euro as the single currency. The other members of the
EU are Bulgaria, Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland, Romania, Sweden, and the United
Kingdom. All 27 members take part in the “economic union” through various forms of policy coordination, a single
market, and single external trade policy, but 16 members have taken economic integration a step further, to the EMU.
Denmark and the United Kingdom were granted special opt-outs of the currency union and are legally exempt from
joining unless their governments decide otherwise, either by parliamentary vote or referendum. Sweden has gained a
de-facto opt-out through the use of various legal provisions. All new members of the EU after 1994 need to adopt the
euro as soon as they meet certain economic policy targets.
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union.” As viewed by German Chancellor Angela Merkel, “the currency union is ... a question, no
more or less, of the preservation of the European idea ... for if the euro fails, Europe fails.”5
A broad range of views exists on the future of the Eurozone. Some academics and journalists
maintain that fears about the long-term viability of the Eurozone are exaggerated. The most
optimistic, in fact, see the crisis as an opportunity to advance the idea of an ‘ever closer union’ by
pursuing greater economic integration and joint coordination of fiscal policy on the European
level. Other academics and journalists maintain that a potential break-up of the currency union, in
part or in whole, cannot be ruled out. While such a development would not necessarily lead to the
demise of the European Union, most observers agree that a break-up would be destabilizing. A
middle-ground perspective holds that Europe has the option to muddle through the crisis by the
introduction a combination of liquidity facilities and reforms that will lower fiscal deficits and
raise economic growth in financially troubled member states.6
The Obama Administration, Federal Reserve (Fed), and Congress have been actively engaged in
monitoring and working towards an orderly resolution of the Eurozone crisis. Initially, a major
U.S. concern was that a sovereign default by Greece could have risked another wave of credit
freeze-ups, instability in the European banking sector, and spillover to global financial markets.
Between February and May 2010, U.S. officials consistently urged their European counterparts to
provide financial assistance to Greece and other vulnerable European economies. The Fed
reactivated temporary swap lines to provide the ECB with liquidity should it be needed.
Congressional concerns centered on the role that the IMF was playing in resolving the crisis.
Other concerns have focused on how slower growth in Europe may affect the U.S. economy, as
well as on how the evolution of the currency union could affect the U.S.-European political
partnership. Given its economic and political importance to the United States, the evolution and
future direction of the Eurozone is of major interest to Congress, particularly committees with
oversight responsibilities for U.S. international economic and foreign policies.
This report provides background information and analysis on the future of the Eurozone in six
parts:
• the first part discusses the origins, rationale, economic significance, key provisions, and
design challenges of the Eurozone;
• the second section describes how persistent economic imbalances are underlying causes
of the Eurozone crisis and analyzes how the imbalances are related to inadequate
adjustment mechanisms within the EMU;
• the third section focuses on proposals to defuse the Eurozone crisis and strengthen the
framework of the currency union;
• the fourth section examines three possible scenarios for the future of the Eurozone: (1)
the Eurozone breaks apart, (2) the Eurozone survives, and (3) the Eurozone becomes
more integrated;
5 Quoted in Financial Times, “Adrift Amid a Rift,” by Ben Hall and Quentin Peel, June 24, 2010.
6 Jacob Funk Kirkegaard, “How Europe Can Muddle Through Its Crisis,” Peterson Institute for International
Economics, December 2010.
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• the fifth section assesses the implications of the Eurozone crisis for U.S. economic and
political interests; and
• a sixth and final section offers concluding observations.
Background on the Economic and Monetary Union
(EMU)
EMU officially stands for Economic and Monetary Union, but it also commonly referred to as the
European Monetary Union. EMU is the agreement among participating countries of the European
Union to adopt a single currency, the euro, and a common monetary policy set by a common
central bank, the European Central Bank.
Origins, Rationale, and Economic Significance
The origins of EMU are closely linked with the international monetary system established after
World War II.7 As part of the post-war reconstruction efforts, countries returned to a gold standard
and created a fixed, but adjustable, system of international exchange rates based on a fixed
exchange rate between the U.S. dollar and the price of gold. The goal was to provide international
monetary stability, facilitate trade, and prevent the competitive devaluations, unstable exchange
rates, and protectionist trade policies of the interwar years. While European leaders had begun the
process of economic integration immediately following World War II, consideration of monetary
union did not begin in earnest until the international monetary anchor provided by the dollar-gold
standard collapsed in 1971 and a new wave of currency instability emerged amidst divergent
national policy responses to several 1970s economic shocks, including the oil crisis.
In 1979, the nine member countries of the European Economic Community (EEC) created the
European Monetary System (EMS). The EMS introduced fixed but adjustable exchange rates
among participating countries’ currencies in order to keep fluctuations of their exchange rates
within acceptable bands. In 1988, the European Commission, then led by Jacques Delors, chaired
a committee which proposed a three-stage plan to reach full economic union. The plan included
the establishment of a European central bank and a single currency that would replace national
currencies.
The EMU officially began on January 1, 1999, when eleven EU members pegged their currencies
at a fixed exchange rate in preparation for adoption of a common currency, the euro. Participating
countries have a common central bank, the European Central Bank (ECB), and by extension a
common monetary policy. Fiscal policy, or decisions about spending and taxation were left to the
individual member states, subject to the 1997 Stability and Growth Pact.
The primary rationale for the EMU was to provide momentum for political union, a long-standing
goal of many European policymakers. Germany and France, Europe’s largest economies, played
the lead role in establishing the EMU, but they have not always agreed on the management and
7 For more information, see Harold James, International Monetary Cooperation Since Breton Woods (Oxford: Oxford
University Press, 1996).
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direction of the single currency. Most observers believe that Germany’s initial support for
monetary union was motivated more by political than economic interests—former Chancellor
Helmut Kohl saw the currency union as an important way to anchor Germany securely in a united
Europe. French leaders, on the other hand, are thought to have viewed the currency union as a key
step to increasing French influence within Europe. Each country subsequently had different
priorities in guiding the development of the monetary union. Germany has insisted that the
Eurozone be anchored in a culture of tight money, low inflation policy, and fiscal discipline.
Accordingly, the ECB’s overriding commitment to price stability is thought to reflect German
preferences. For its part, France has pushed for more flexibility in European monetary policy and
for more political control over the inflation-fighting ECB.8
Although political goals were the driving force in the move towards monetary union, discussions
of EMU also focused heavily on its economic costs and benefits. Generally, European monetary
union was expected to make Europe’s economy more efficient, thereby raising the living
standards of Europe. For example, it would eliminate the transaction costs of changing one
currency into another, which would benefit both consumers and producers. Additional economic
benefits included lowering the cost of trading goods by removing exchange rate risk and currency
conversion fees and, by facilitating price comparisons of goods and services across national
borders. Cost savings that arise from greater competition also induce direct investment from non-
Eurozone countries as foreign firms attempt to locate facilities within the Eurozone area to access
a larger market. Proponents of the EMU also wanted the euro to become one of the reserve
currencies of international finance, alongside the dollar and the yen.9
The now 17 members of the Eurozone have considerable economic heft. Comprising some 320
million people, the gross domestic product (GDP) of the entire Eurozone area was $13.6 trillion
in 2008,10 or about 22% of world GDP. By comparison, the GDP of the United States in 2008 was
slightly larger at $14.1 trillion. Within the Eurozone, economic weight is heavily concentrated in
a few large countries. More than 77% of the Eurozone’s total GDP is accounted for by just four
countries (Germany, France, Italy, and Spain). In contrast, the Eurozone’s five smallest countries
(in decreasing size: Slovakia, Slovenia, Luxembourg, Cyprus, and Malta) accounted for less than
2% of the Eurozone’s overall GDP in the same year.
The Eurozone is also a major player in the world economy. As a whole, it accounted for 29% of
total world exports; 28% of world imports; and 23% of world net inflows of foreign direct
investment (FDI) in 2008.11 The United States also has a strong bilateral economic relationship
with the Eurozone.12 With respect to trade, U.S. exports to Eurozone members totaled $162.7
billion in 2009, representing 15% of total U.S. exports. Likewise, the value of U.S. imports from
8 Katina Borsch, “Germany, The Euro and Politics of the Bail-out,” Centre for European Reform, Briefing Note, June
2010.
9 For further background on the economic costs and benefits of monetary union with a focus on the EMU, see Paul De
Grauwe, Economics of Monetary Union (Oxford: Oxford University Press, 2009).
10 World Bank’s World Development Indicators database. Data in current US$.
11 World Bank’s World Development Indicators database. Data in current US$.
12 For more on the bilateral economic relationship between the United States and the EU, see CRS Report RL30608,
EU-U.S. Economic Ties: Framework, Scope, and Magnitude, by William H. Cooper.
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the Eurozone in 2009 was $216.5 billion, or 13% of total U.S. imports.13 In terms of capital flows,
U.S. investors on net repatriated $128.2 billion dollars from the Eurozone in 2009.14
Key Provisions of the EMU
The blueprint for the EMU was formalized in provisions of the 1992 Maastricht Treaty, the
founding document of the present-day European Union. The Treaty established the conditions, or
“convergence criteria,” that countries are required to meet before they join the EMU.15 By
requiring the members to adhere to similar economic policies, the convergence criteria are meant
to promote a more balanced economic growth and development among the various members of
the Eurozone. This, in turn, was thought to make it easier for diverse economies to share a single
currency.
EU Treaties
The Treaty on European Union (TEU or the Maastricht Treaty) is the founding document of the modern European
Union. Together, the TEU and the 1957 Treaty establishing the European Economic Community (also known as the
Rome Treaty or the EEC Treaty, and recently re-named the Treaty on the Functioning of the European Union, or
TFEU) define the objectives and principles of the EU and set out the EU’s institutional architecture and organizational
rules. The Lisbon Treaty, which entered into force in December 2009, is the most recent treaty amending these
documents.
Consolidated versions of the TEU and the TFEU are available in the Official Journal of the European Union, March 30,
2010, available at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2010:083:FULL:EN:PDF
As an integral part of the EMU, a European Central Bank (ECB) was established to set monetary
policy independent of any political influence. The ECB together with the central banks of all the
members of the European Union form the European System of Central Banks, or ESCB, which is
charged by statute with maintaining price stability as its primary objective. The formulation of
price stability as a primary ESCB objective, compared to the U.S. Federal Reserve’s multiple
mandates of price stability, full employment, and moderate long-term interest rates, was a German
pre-condition for sacrificing the Deutsche mark.16
There was no provision in the Maastricht Treaty to allow the ECB to act as a lender of last resort
to Eurozone members in the case of a financial crisis. According to the EMU’s design, each
member must finance its deficits by itself. A “no-bail-out” clause explicitly stipulates that neither
the European Union nor any member state is liable for or can assume the debts of any other
13 Cost-in-freight data.
14 U.S. Department of Commerce, Bureau of Economic Analysis, http://www.bea.gov.
15 To participate in the initial formation of the EMU, each member had to meet the following five convergence criteria
by 1998: (1) national legislation governing the country's financial system had to be compatible with the treaty
provisions controlling the European System of Central Banks; (2) a rate of inflation within 1.5% of the rates in the
three participating countries with the lowest rates; (3) reduction of its government deficits to below 3% of its gross
national product; (4) currency exchange rates within the limits defined by the Exchange Rate Mechanism (ERM) (an
intermediary step toward a single currency that attempted to stabilize exchange rates by fixing rates through variable
bands) for at least two years; and (5)interest rates within 2% of the rates in the three participating countries with the
lowest rates.
16 Paul De Grouse, Economics of Monetary Union.
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member state.17 However, EU financial assistance is allowed in case of “severe difficulties caused
by natural disasters or exceptional occurrences beyond the control of a member state.”18
For the mutual assurance and stability of the currency, all members are constrained in their ability
to adopt independent fiscal policies by the Protocol on Excessive Deficit Procedure (EDP) and
the Stability and Growth Pact (SGP). The EDP is a procedure under which member states are
obliged to avoid excessive deficits in national budgets.19 The SGP, agreed to in 1997, was
intended to deepen multilateral surveillance and “speed up and clarify” implementation of the
EDP.20
Soon after the SGP took effect in 1999, EU members began criticizing the rules-based approach
of the Pact for being too stringent and they questioned whether the rules could be enforced. In
2003, the weaknesses of the Pact were exposed when the European Council voted against
applying the punitive procedures under the EDP to France and Germany, which had experienced
rising levels of government debt. Some EU members argued that the Pact focused too heavily on
the rules-based percentage guidelines without regard for the circumstances under which a
government’s level of debt or its deficit spending may rise, for instance as a result of a temporary
increase in government spending to counter an economic downturn.21
In 2005, the EU members adopted a number of changes to the Stability and Growth Pact. These
changes made enforcement more flexible to take into account the economic conditions of the
member states, and other factors. For example, the modified Pact provides for each EU member
to develop its own medium-term objectives to bring its deficit spending and its debt level into
compliance based on the unique economic conditions of each member. The changes also allow
EU members to avoid the corrective measures in cases where their annual fiscal deficit exceeds
17 Article 125 TFEU is often referred to as the EU’s “no-bailout” clause. It states:
The Union shall not be liable for or assume the commitments of central governments, regional,
local or other public authorities, other bodies governed by public law, or public undertakings of any
Member State, without prejudice to mutual financial guarantees for the joint execution of a specific
project. A Member State shall not be liable for or assume the commitments of central governments,
regional, local or other public authorities, other bodies governed by public law, or public
undertakings of another Member State, without prejudice to mutual financial guarantees for the
joint execution of a specific project.
18European leaders drew reference to these exceptions (Article 122(2) TFEU) in crafting new crisis management
facilities. They explicitly based the bailout actions on the grounds that the debt crisis endangered the solvency of entire
states and posed a serious threat to the euro and financial stability of the monetary union. For a contrary view that the
euro was endangered by the crisis, see Hans-Werner Sinn, “Rescuing Europe,” CWSifo Forum, Volume 1, August
2010. Sinn argues that the bailout was engineered primarily to protect French, and to a lesser extent, German banks.
19 The Protocol on Excessive Deficit Procedure established a mechanism for countries to meet the specific guidelines
that are applied under Article 104 of the Maastricht Treaty. Under this protocol, EU members are expected to have an
annual budget deficit no greater than 3% of GDP at market prices and government debt no more than an amount
equivalent to 60% of GDP.
20 The Stability and Growth Pact (SGP) is an agreement by European Union members to conduct their fiscal policy in a
manner that facilitates and maintains the EMU. The Pact is based on Articles 99 and 104 of the Maastricht Treaty, and
related decisions. It consists of (1) a political commitment by all parties involved in the SGP to the full and timely
implementation of the budget surveillance process; (2) regular surveillance aimed at preventing budget deficits from
going above the 3% reference value; and (3) corrective elements which require member states to take immediate action
when the 3% reference value is breached or face the imposition of sanctions.
21 Beetsma, Roel M.W.J., and Xavier Debrun, Implementing the Stability and Growth Pact: Enforcement and
Procedural Flexibility, IMF Working Paper WP/05/59, International Monetary Fund, March 2005.
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3% of GDP, if they can demonstrate that the deficit is caused by “exceptional and temporary”
circumstances.
Design Challenges
From the start of the euro area, various academics and policymakers argued that a single currency
for many different economies would face numerous challenges and some even argued that it was
bound to fail. According to these critics, a big weakness of the project was the lack of a common
fiscal policy to support it. This, in turn reflected the fact that it was a currency with a central bank
but without a government that has taxation and spending authority. The creation of the euro also
meant that members of the Eurozone lost their ability to use monetary and exchange rate policy
tools as a way to respond to changes in economic conditions.22
The loss of monetary and exchange rate tools, combined with a lack of a common fiscal policy,
creates vulnerabilities and tensions because members of the Eurozone are constrained in how they
respond to economic shocks such as a recession. Countries are different and in a recession are
likely to experience different unemployment rates. In a currency union, the central bank will set a
common interest rate that may end up too high for the high unemployment country, resulting in
lost employment and output, and too low for the low unemployment country, resulting in excess
spending and consumption, and exacerbating the business cycle in both countries.
Despite these costs, joining a currency union may be advantageous as long as there are
adjustment mechanisms that ensure that the benefits of membership such as lower transaction
costs and exchange rate certainty exceed the costs. These adjustment mechanisms, in the absence
of a common federal budget and robust transfer mechanisms from countries experiencing booms
to the countries experiencing recessions, include labor and capital mobility and wage and price
flexibility. For example, the unemployment disparities could be reduced if workers from a
country with high unemployment relocated to the one with low unemployment. Or, relative labor
costs could fall in the high unemployment country to attract investment and create new jobs. In
the absence of viable adjustment mechanisms, there are likely to be strains and tensions within a
currency union.23
The functioning of the dollar in the U.S. economy, despite major differences among its fifty
states, is facilitated by adjustment mechanisms that are either absent or deficient in the Eurozone.
For example, U.S. unemployed workers move much more freely from Maine to Minnesota than
do European unemployed workers move from Spain to Slovenia because of differences in
language and regulations. Prices of basic consumer durables vary little among the U.S. states but
can be substantial among the members of the Eurozone. And the federal government in
Washington collects roughly two-thirds of all taxes and provides net fiscal transfers to states with
temporarily falling incomes. No such substantial fiscal transfers occur in the Eurozone.24
Just as critical to lacking a common federal budget to transfer resources from countries
experiencing booms to countries experiencing recessions, the single currency can weaken the
22Martin Feldstein, “The Euro’s Fundamental Flaws,” The International Economy, Spring 2010, p. 11.
23 Faltin, Dirk, and Katherine Klingensmith, “Eurozone Economics: The Future of the Euro in Jeopardy,” UBS Wealth
Management Research, July 13, 2010.
24Martin Feldstein, p.12.
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market signals that would otherwise warn a member that its fiscal deficits were becoming
excessive. When a country with excessive deficits needs to raise taxes and cut government
spending, as many Eurozone countries need to now, the resulting contraction in output and
employment cannot be moderated by a devaluation that increases exports and decreases imports.
These shortcomings or design flaws inherent in the architecture of the currency union played a
role in the sovereign debt crisis that hit Greece and several other Eurozone members in early 2010
and are discussed in the next section.
Economic Imbalances and Adjustment Mechanisms
within the Eurozone
At the time of the euro’s launch in 1999, a number of economists predicted that the monetary
union would not survive because of shortcomings in its architecture. This section describes (1)
the persistent economic imbalances that are at the heart of the current crisis; and (2) how the
imbalances are related to the institutional constraints of the monetary union itself, particularly the
lack of adequate adjustment mechanisms.
Imbalances within the Eurozone
When the euro was introduced, many economists expected that the national economies within the
Eurozone would achieve additional convergence. However, many of the Eurozone economies
have remained quite different or have actually diverged in a number of economic dimensions over
the past decade. This divergence is generally thought to have occurred broadly between two
groups of countries within the Eurozone: the Northern European countries, including Austria,
Belgium, Germany, Finland, France, Luxembourg, and the Netherlands; and a group of mostly
Southern European countries, including Greece, Ireland, Italy, Portugal, and Spain. These latter
five countries are referred by the acronym “GIIPS” throughout this report.
Figure 1 shows average economic trends in these two groups of countries over the past decade.
Prior to the outbreak of the global financial crisis in 2008, the GIIPS experienced higher rates of
economic growth on average than the Northern European countries. However, the GIIPS also
generally experienced faster growth in prices (inflation), including faster growth in the
compensation for workers (adjusted for differences in worker productivity). This resulted in a loss
of industrial competitiveness for the GIIPS and an increase in industrial competitiveness for the
Northern European countries. As a result, the GIIPS on average ran trade deficits, while the
Northern European countries generally ran large trade surpluses. The GIIPS also generally ran
larger government budget deficits (relative to GDP) and accumulated higher levels of government
debt (relative to GDP) than Northern European countries.
Much of the money that the GIIPS borrowed to finance trade and budget deficits came from
banks located in the Eurozone, particularly French and German banks.25 The exposure of French
and German banks to the GIIPS rose from $357.2 billion in December 1999 to $1.6 trillion in
25 Bank for International Settlements (BIS), International Banking and Financial Market Developments, BIS Quarterly
Review, June 2010, http://www.bis.org/publ/qtrpdf/r_qt1006.pdf.
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December 2009, an increase of more than 450%.26 These sums, in turn, are in part a mirror image
of the GIIPS and Northern European countries where the net borrowers are being financed by the
net savers.
26 Bank for International Settlements (BIS), “Consolidated International Claims of BIS Reporting Banks,” Publication
data up to 2009Q4, June 2010, Table 9B: Consolidated Foreign Claims of Reporting Banks - Immediate Borrower
Basis, http://www.bis.org/statistics/consstats.htm.
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Figure 1. Economic Trends in the Eurozone
Source: GDP and inflation data are from the IMF’s World Economic Outlook database. Unit labor cost are from
the Source OECD database. Trade data is from the World Bank’s World Development Indicators. Budget and
debt data are from European Commission, Directorate General Economic and Financial Affairs, General
Government Data, Part II: Tables by Series, Spring 2010,
http://ec.europa.eu/economy_finance/db_indicators/gen_gov_data/documents/2010/spring2010_series_en.pdf.
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Notes: GIIPS refers to Greece, Ireland, Italy, Portugal, and Spain. Northern Eurozone countries include Austria,
Belgium, Germany, Finland, France, Luxembourg, and the Netherlands. Four countries that have joined the Euro
zone in 2007 or later (Cyprus, Malta, Slovenia, and Slovakia) are not included. Unweighted averages used. Unit
labor costs (for the total economy) were used. Trade data are for goods and services. Budget data are for
general government (central, state, and local levels) as a percentage of GDP at market prices. Debt data are
general government (central, state, and local levels) consolidated gross debt as a percentage of GDP at market
prices.
Adjustment Mechanisms
Differences between the economies of Northern Europe and the GIIPS can be attributed to a
number of factors, including policy choices.27 For example, Germany’s export-led economic
strategy and commitment to wage moderation is often cited as a factor for its low costs of
production and trade surpluses.
However, many have suggested that the imbalances are caused by the institutional arrangements
of the currency union itself and its inadequate adjustment mechanisms. This argument typically
proceeds as follows:28 After the GIIPS adopted the euro, investors viewed these countries as safer
destinations for investment, and the interest rates paid by the GIIPS on their government bonds
fell to the interest rates paid by Northern European countries. As a result, interest rates in the
GIIPS were far too low, leading to distorted investment decisions and ultimately overinvestment
in a number of sectors. As private sector borrowing and demand increased, the GIIPS launched
investment projects to allow growth to take place with less inflation. This, in turn, required
increased borrowing, particularly from banks in Northern European countries, and contributed to
larger government budget deficits.
Capital inflows into the GIIPS fueled domestic demand, leading to high levels of growth, but also
to inflation. Increasing prices in the GIIPS reduced their competitiveness, and consequently,
caused the GIIPS to start running current account deficits (see Figure 2).29 Each year’s current
account deficits added to the public and private aggregate debt of the GIIPS. As part of this
process, the GIIPS accumulated foreign debt which rose close to 80% of GDP.30
27 Gilles Saint-Paul, “Is the Euro a Failure?”, VoxEU, May 5, 2010.
28 Uri Dadush and Bennett Stancil, “Europe’s Debt Crisis: More than a Fiscal Problem,” in Paradigm Lost: The Euro in
Crisis, ed. Uri Dadush and Contributors (Carnegie Endowment for International Peace, 2010), pp. 9-15.
29 The current account is the sum of the balance of trade (exports minus imports of goods and services), net factor
income such as interest payments and dividends, and net transfer payments such as foreign aid. Measures to reduce a
current account deficit usually involve increasing exports or decreasing imports. Economists tend to argue that this can
be accomplished most effectively by increasing domestic savings or reducing borrowing of households and
government.
30 Dirk Faltin and Katherine Klingensmith, “Eurozone Economics: The Future of the Euro in Jeopardy,” p. 6.
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Figure 2. Selected European Current Account Balances
Percent of GDP
Source: International Monetary Fund
Meanwhile, most Northern European economies did not face dramatic reductions in their interest
rates upon joining the Eurozone and did not have substantial increases in capital inflows.
Combined with fiscal policies that aimed to contain domestic demand, the Northern European
countries as a result had lower inflation and remained more competitive than their GIIPS
counterparts. Partly due to their relative competitiveness, the Northern European countries were
able to export to the GIIPS and run large current account trade surpluses.31
Some suggest that being in the Eurozone constrained the ability of the GIIPS governments to
respond to growing divergences from the Northern European countries.32 For example, if the
GIIPS had not been in the Eurozone, they could have reduced their trade deficits through
currency depreciation. Likewise, these observers argue, the GIIPS could have raised interest rates
to slow economic growth in response to a potentially over-heating economy. But for countries in
the Eurozone, neither devaluation nor an increase in interest rates is an option.
The GIIPS did retain some control over their fiscal policy and could have reined in government
spending or raised taxes in order to curb consumption. Such a policy could have freed up
resources for payments to foreign creditors. However, as discussed previously, the low interest
rates resulting from Eurozone membership increased the attractiveness of government deficit
31 Given that about 75% of all Eurozone trade constitutes exports of one Eurozone member to another (so-called “intra-
Eurozone trade”), the trade surpluses of one Eurozone country or group of countries are to a large extent matched by
the deficits of others.
32 Gilles Saint-Paul, “Is the Euro a Failure?”, VoxEU, May 5, 2010.
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spending, and the GIIPS countries generally borrowed, running budget deficits. Alternatively,
given that inflation was twice as high in the GIIPS than the EMU average, real interest rates (i.e.,
nominal rates minus inflation) were extremely low, thereby discouraging savings and causing
private firms and households to run up debt to finance consumption and housing construction,
especially in Spain and Ireland.33
Given their membership in the Eurozone, the GIIPS are left with using deflation (decreases in
wages, incomes, and prices) in order to reduce their trade deficits. However, deflation may have
little beneficial effect on the foreign debt positions of most of the GIIPS if they all pursue the
same strategy simultaneously. This is because the negative effects on economic growth and
employment could be compounded, weakening the economies of the GIIPS to the point where
their debt-to-GDP ratios continue to rise.34
In sum, the trade imbalances between the Northern countries and GIIPS provide evidence that the
EMU’s internal adjustment mechanisms are not working well. Whatever labor mobility and price
flexibility that exists in the Eurozone, combined with limited fiscal transfers, did not prevent the
accumulation of persistent trade imbalances and the sovereign debt crisis. While improved labor
mobility and price flexibility may be long-term solutions, European leaders and institutions are
now considering a range of proposals to increase fiscal coordination and integration as the best
way to shore-up the EMU’s institutional shortcomings.
Eurozone Crisis Measures and Reform Proposals
Beginning in May 2010, European leaders and institutions adopted an unprecedented package of
emergency measures to halt rising financial market tensions stemming from concern about the
fiscal solvency of Greece and several other Eurozone countries. This section first discusses the
emergency crisis measures adopted by EU national governments and European institutions to
defuse the crisis. It then discusses reform proposals for economic governance and economic
policies.
Emergency Crisis Measures
Since the start of the Eurozone crisis, member governments have created a €110 billion finance
assistance program for Greece, a €60 billion European Financial Stabilization Mechanism
(EFSM), and a €440 billion European financial stability facility (EFSF). Each facility is described
below along with the roles played by the IMF and the ECB in crisis management. These measures
are summarized below in Table 1.
33 Dick Faltin and Katherine Klingensmith, “Eurozone Economics: The Future of the Euro In Jeopardy,” p.5.
34 Ibid., p. 8.
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Table 1. Eurozone Emergency Crisis Measures
EU Loan to Greece
€80 billion
IMF Loan to Greece
€30 billion
European Financial Stability Facility (EFSF) €440
billion
European Financial Stability Mechanism (EFSM)
€60 billion
Potential IMF contribution €250 billion
ECB Purchases of Government Bonds
€61 billion (through September 8, 2010)
Sources: ECB, EU, IMF
Greece Package
On May 2, 2010, the Eurozone member states and the IMF announced a three-year, €110 billion
financial assistance package for Greece (€80 billion from member states and €30 billion from the
IMF). The Eurozone member states are providing assistance to Greece on a bilateral basis with
the European Commission tasked exclusively with coordinating and managing the loans.
Eurozone member state loans to Greece are structured bilaterally because at the time of the
agreement, there was no EU-level mechanism to provide balance of payments support to a
Eurozone member country. In exchange for the financial assistance, the Greek government has
pledged to reduce Greece’s government budget deficit from 13.6% of GDP in 2009 to below 3%
by 2014. The IMF has referred to this program as unprecedented in terms of the adjustment effort
required by the government.35
Despite the announcement of the Greek package on May 2, 2010, financial market pressures
continued to worsen over the ensuing days as the value of the euro declined, stock markets
declined, and bond spreads of several southern European countries widened sharply over the
following weeks. On May 10, 2010, EU officials announced a rescue package of up to €750
billion to restore confidence in EMU members’ fiscal sustainability. This consists of two new
European financing entities, the European Financial Stability Mechanism (EFSM) and the
European Financial Stability Facility (EFSF). The IMF is also expected to make contributions as
well as play a coordinating role, as it has much expertise in financial surveillance and putting
together sovereign debt packages.
European Financial Stability Mechanism
The EFSM is a new €60 billion supranational EU balance of payments loan facility available to
any EU member country facing financial difficulties. It is similar in design to an existing €50
billion EU balance of payments facility that can only be drawn on by non-Eurozone EU member
nations.36 Since 2008, Hungary, Latvia, and Romania have borrowed from this facility as part of
joint EU-IMF economic adjustment programs.
Under the new EFSM, the European Commission is allowed to raise up to an additional €60
billion on the international capital market by issuing bonds individually and collectively backed
35 IMF, “Frequently Asked Questions: Greece,” May 11, 2010, http://www.imf.org/external/np/exr/faq/greecefaqs.htm.
36 The current balance of payments facility was created under Article 143 of the Lisbon Treaty, which limits assistance
to “member states with a derogation,” i.e., those outside the Eurozone.
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by all 27 EU member states.37 EFSM loans require a qualified majority vote of the Council of the
EU. The borrowing nation would be subject to economic conditionality supervised by the
European Commission, which would decide at regular intervals whether sufficient economic
progress has been made to warrant the continued release of funds. Funds are available
immediately and there is no sunset date for the EFSM. To date, no country has requested funds
from the EFSM.
European Financial Stability Facility
European leaders decided to provide the majority of the rescue package, up to €440 million, in a
temporary three-year crisis prevention facility, the so-called European Financial Stability Facility
(EFSF), outside of the EU system. The EFSF has been established under Luxembourg law as a
limited liability corporation.38 This allows participating countries to have greater discretion over
the use of the facility’s resources—decisions are made by a board of directors from participating
countries instead of the European Commission—and to limit their liability to the amount of their
individual guarantee. The amount of a country’s guarantee is to be derived from their respective
contributions to the paid-in capital of the ECB.
If a country needs to borrow from the facility, it can leave the EFSF for a period of time per
unanimous agreement of the remaining participants. This agreement has already been reached for
Greece. Eurozone member states have committed to provide a 120% guarantee of their share to
ensure sufficient capital in case other countries need it. It is expected that this facility will be used
only under strict conditions of conditionality in order to minimize the risk of moral hazard.39
As it is currently structured, the EFSF is a temporary facility that will expire in 2013. Whether
this crisis mechanism, which may operate as a Eurozone version of the IMF, should be made
permanent is the subject of on-going discussions. The procedures or criteria that will be used to
identify circumstances under which countries will be allowed to borrow from the facility is also a
work in progress.
Participation of the International Monetary Fund
The IMF is expected to participate in any loans made by the EFSM and EFSF, and to provide at
least half as much as the EU contribution, potentially up to €250 billion (half of the combined €60
billion EFSM and €440 billion EFSF).40 The IMF, however, cannot pre-commit funds for a group
of countries. Any IMF contributions to loan packages for Eurozone members will be on a
country-by-country basis. Any such loan would also be subject to the approval of the IMF
Executive Board in the same manner as all IMF lending arrangements.
37 Council Regulation (EU) No. 407/2010 of 11 May 2010 establishing a European financial stabilization mechanism.
Official Journal of the European Union, December 5, 2010. L 118/1.
38 Council of the European Union, Press Release, Extraordinary Council Meeting, Economic and Financial Affairs,
Brussels, May 9/10, 2010.
39 Deutsche Bank Research, “European Governance: What does the future holds,? August 6, 2010. Moral hazard is a
term that refers to situations when a party insulated from risk behaves differently than it would behave if it were fully
exposed to the risk.
40 Ibid.
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In the case of the EFSF, the IMF is to play a role in determining whether a country’s fiscal
situation merits assistance. If it does, the IMF must also approve a consolidation plan.
European Central Bank Response
Along with the creation of the EFSM and the EFSF, the European Central Bank has implemented
several crisis-response measures to improve European financial stability. Arguably the most
important of these measures is the ECB’s decision to purchase European sovereign debt outright
in the secondary markets. This was a significant policy reversal for the ECB, which had long
viewed interventions in sovereign debt markets as compromising its independence, and a
diversion from its core mandate of price stability. However, as it required several months to
legally establish the EFSM and the EFSF, the ECB was able to provide immediate support
following the worsening of the crisis in early May. The ECB began interventions on May 10,
2010, purchasing €16.5 billion of Eurozone sovereign debt.41 As of July 20, 2010, the ECB held
around €60 billion of European government bonds.42
The ECB also created a collateral waiver for Greece so that Greek sovereign debt can be used as
collateral for loans to the European banking system. Under previous rules, Greek bonds would no
longer have been accepted by the ECB, putting additional pressure on the European banking
system.
Other ECB policy measures include the reactivation of temporary liquidity swap lines with the
U.S. Federal Reserve. In addition to the ECB, the Fed re-activated temporary reciprocal currency
agreements, known as swap lines, with the Bank of Canada, the Bank of England, Bank of Japan,
and the Swiss National Bank.43 The swap lines with the Federal Reserve provide foreign central
banks with a source of dollar financing should such immediate liquidity be needed. Since their
reactivation, the use of these swap lines has been very limited.
Ireland Package
Notwithstanding the announcements of the EFSM and the EFSF in May 2010, during the fall
2010, the uncertain outlook for government budgets in Ireland and some other Eurozone countries
again became a concern. On November 28, 2010, European and IMF authorities announced a
three-year, €85bn ($112 billion) assistance package for Ireland. Of the total amount, €10bn will
be available for the immediate recapitalization of the banking sector, €25bn will be set aside in a
contingency fund, and the remaining €50bn will be available in the event that the Irish
government is unable to raise money in the capital markets in 2011. Table X provides a
breakdown of the loan and a text box provides information on the two European facilities.
41 David Oakley, Peter Garnham, and Ralph Atkin, “ECB reveals €16.5bn bond purchases,” Financial Times, May 17,
2010.
42 Andrew Ross Sorkin, “ECB Winds Down Debt Purchases,” New York Times, July 20, 2010.
43 In response to the beginnings of the recent financial crisis, similar swap lines were established in December 2007 and
expired in February 2010. On the re-establishment of these lines, see Federal Reserve, “Federal Reserve, European
Central Bank, Bank of Canada, Bank of England, and Swiss National Bank Announce Reestablishment of Temporary
U.S. Dollar Liquidity Swap Facilities,” http://www.federalreserve.gov/newsevents/press/monetary/20100509a.htm and
Federal Reserve, “FOMC Authorizes Re-establishment of Temporary U.S. Dollar Liquidity Swap Arrangement with
the Bank of Japan,” http://www.federalreserve.gov/newsevents/press/monetary/20100510a.htm.
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Table 2. The EU/IMF Irish Loan
Source of Financing
Billions of Euros
Total Program Value
85.0
Of which:
Contributions from Ireland
17.5
IMF 22.5
European Financial Stability Mechanism
22.5
European Financial Stability Facility
17.7
United Kingdom
3.8
Sweden 0.6
Denmark 0.4
Source: EU Commission
Economic Governance Reforms
Crisis response measures have succeeded in stabilizing financial markets, but they are temporary
measures that do not address fundamental weaknesses in the architecture of the EMU. The
temporary measures, however, have provided European leaders with time to consider changes in
the governance of the currency union. Initial agreement has been reached on a permanent EU
crisis fund. Proposals have also focused on developing more effective means of coordinating
national fiscal policies and on promoting faster and more balanced growth. These are described
briefly below.
Fiscal Policy Reforms
As discussed earlier, there is pressure to reform the current framework for European fiscal policy
coordination. On June 17, 2010, the Council of European Heads of State released a synopsis of
current proposals for reform of the Stability and Growth Pact.44 On surveillance, leaders agreed to
give public debt and debt sustainability issues a more prominent role in budgetary surveillance.
EU leaders agreed to a national budgets peer review system under which governments will submit
to the European Commission draft budgets for peer review and coordination before they are
finalized. EU leaders also agreed to sanctions, in principle, for countries with excessive debt
levels, but did not specify what form these sanctions would take. France and Germany have
proposed suspending the voting rights of European Union members who persistently exceed
budget deficit limits, but neither the suspension of voting rights, nor automatic sanctions were
agreed at the June 2010 European Council summit. The IMF has also argued that the European
Union needs to strengthen the enforcement procedure, including sanctions, when countries are
violating deficit limits.
On October 29, 2010, EU leaders announced agreement on a permanent crisis resolution
mechanism to replace the €440 billion EFSF facility when it expires in 2013. Negotiations on the
design of the so-called European Stability Mechanism (ESM) are ongoing, however, minor
44 European Council, European Council, Conclusions, 17 June 2010, EUCO 13/10, Brussels, June 17, 2010.
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changes in the Lisbon Treaty, required to allow for the creation of an EU institution to provide aid
to a Eurozone country were agreed to in December 2010. According to the ESM proposal,
private bondholders might have to share the burden of any future default by a Eurozone member.
Private sector participation would not be automatic, but rather, decided on a case-by-case basis.
In addition, from 2013 onwards, all euro area government bonds will include collective action
clauses (CACs), which allow a majority of bondholders to agree on a debt restructuring that
would be binding for all bondholders. In the past, the absence of any international legal protection
for bankrupt countries has complicated several previous defaults. CACs gained currency in 2003,
following the failure of the IMF’s Sovereign Debt Restructuring Mechanism proposal, which
would have, broadly speaking, created a sovereign bankruptcy court. According to the ESM
proposal, funds provided through the ESM will rank senior to private-sector holdings in any
future restructuring.
It remains undecided which EU actor will decide whether the sovereign debt of a Eurozone
country is unsustainable and needs to be restructured, and on what terms. While some analysts
have proposed the European Commission as the deciding actor, others have pointed out that they
would be inappropriate since EC, as well as the ECB and other European governments would
likely be creditors and thus have a potential conflict of interest. Also to be decided is whether
there will be guarantees provided on bondholders remaining principal after a restructuring.45
Economic Growth Policies
Important for securing the long-term viability of the EMU is reversing several years of weak
economic growth. The Economic Intelligence Unit forecasts a Eurozone economic growth rate at
0.7% for 2010 and 0.8% for 2011, while the IMF analysis forecasts GDP growth at around 1% in
2010, increasing only to 1.25% in 2011.46 Because higher rates of economic growth may help
avoid future debt crises, priority is being given to addressing structural problems such as labor
and service sector barriers, as well as to macroeconomic policies and surveillance for promoting
stronger and more balanced economic growth.
For all Eurozone countries, the ECB and the European Commission have stressed the importance
in their view of pressing forward with difficult structural reforms that have prevented the
completion of the European common market. Removing remaining trade barriers, especially in
the services sector, is viewed by the ECB and the EC as being particularly important for
increasing growth. According to the ECB, only 20% of services provided in the EU have a cross-
border dimension. A full implementation of the European Commission’s services liberalization
proposals could increase EU GDP growth rates by 0.6-1.5 percentage points.47 Other growth
enhancing EU-wide reform efforts include promoting a common energy market and accelerating
the implementation of new digital technologies in accordance with the objectives of the Europe
2020 growth strategy.
45 Willem Buiter, Ebrahim Rahbari, Jurgen Michels, Giada Giani, Chief Economist Essay – Sovereign Debt Crisis
Update, Citigroup Global Markets, November 29, 2010.
46 International Monetary Fund, Euro Area Policies: 2010 Article IV Consultation, Washington, DC, July 2010.
47 Lorenzo Bini Smaghi, Imbalances and Sustainability in the Euro Area, European Central Bank, Presentation at the
ECB and its Watchers Conference, Frankfurt, July 9, 2010.
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Proposals on stricter macroeconomic surveillance specify the use of a scorecard for assessing
changes in competitive positions and flagging emerging macroeconomic imbalances in a timely
fashion. While these proposals still need to be fleshed out, it is unclear how they will address the
current account imbalances within the Eurozone. In this context, much concern and weight may
be placed on Germany, the largest economy of the Eurozone, to increase internal demand and
thereby buy more goods and services of the GIIPS as they become more competitive.48 Recent
movements in the exchange value of the euro are boosting exports from Eurozone countries, but
the benefits are not being shared equally among the Eurozone members. Since movements in the
exchange value of the euro do not affect the comparative levels of productivity among Eurozone
members, those members with higher levels of productivity, such as Germany, tend to benefit the
most. To the extent that other Eurozone members are similarly looking to spur their economic
growth by increasing exports, they likely will provide little stimulus to Greece and Spain or to
other Eurozone members.
From a different perspective, many Germans reject the notion that their exporting success and
trade surpluses come at the expense of fellow Eurozone members. They argue that exports allow
the German economy to grow faster, and in the process absorb more imports from their Eurozone
neighbors. Furthermore, they maintain that other Eurozone countries, such as Greece and Spain,
can increase their competitiveness just as Germany has done by cutting costs and making
specialized products.49
Possible Scenarios for the Future of the Eurozone
The current debt crisis has arguably posed the most fundamental challenge to the Eurozone since
the euro was introduced a decade ago and has led to speculation about the future of the Eurozone.
Three scenarios have typically been discussed: (1) the crisis leads to a splintering or break-up of
the Eurozone, with one or more members abandoning the euro; (2) the Eurozone survives the
crisis largely intact, without major reforms; and (3) substantial reforms to the Eurozone
architecture are implemented, leading to greater economic and political integration. The outcome
of the crisis will likely be influenced by a host of factors, including market confidence,
commitments to reform packages, and the willingness of Eurozone member states to relinquish
greater control over economic issues to the European level, among others.
Scenario 1. The Eurozone Breaks Apart
It was once considered unthinkable that countries would leave the Eurozone, but the debt crisis
facing several southern European countries has raised the possibility that one or more countries
could exit the Eurozone. Exiting the Eurozone would entail countries abandoning the euro as their
national currency, issuing a new national currency, and allowing the new national currency to
appreciate or depreciate against the euro.
48 Michael Pettis, “The Risk of Another Global Trade War,” Financial Times, August 24, 2010, p. 9.
49 Christian Riermann, “How Germany’s Export Strength Helps Its Neighbors,” Spiegel Online, August 24, 2010.
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Exit by One or More Southern European Countries
Typically, the discussion about the Eurozone breaking apart focuses on one or more southern
European countries deciding to leave the Eurozone. There has also been some discussion about
southern European countries being pushed out of the Eurozone by northern European countries.
For example, as European leaders discussed the response to the Greek debt crisis, it is reported
that in March 2010, German Chancellor Angela Merkel tacitly endorsed a proposal that would
allow weak Eurozone member states to be “ejected” from the Eurozone.50
Perhaps the strongest motivation for southern European countries to exit the Eurozone would be
to allow their resulting new national currencies to depreciate against the euro. This would help the
southern European countries regain competitiveness against the northern European countries,
likely leading to an increase in their exports and a decrease in their imports. It is argued that a
surge in exports would spur economic growth and offset the effects of the austerity measures
being undertaken by southern European countries to pay down their debt. It is also thought that
these new national currencies would help to correct the trade imbalances that have developed
within the Eurozone and, as southern European countries borrowed to finance their trade deficits,
that have contributed to the accumulation of debt in these countries over the past decade.
Exiting the Eurozone would involve potentially huge costs for the southern European economies,
however, for at least four reasons. First, the debt of southern European countries is denominated
in euros, and leaving the Eurozone in favor of a depreciated national currency could significantly
raise the value of their debt in terms of national currency. Second, there are technical and legal
obstacles to exiting the euro.51 Legislation would likely be required to issue the new national
currency, and all contracts involving euros would have to be rewritten for the national currency.
Numerous electronic machines involving euros, including computers, ATMs, and vending
machines, would have to be reprogrammed or replaced, and new printing presses would be
needed. Third, as investors and consumers anticipated that the new national currency would
depreciate in value against the euro, massive capital flight from the country could trigger a major
financial crisis in the country and put pressure on other vulnerable European countries. This could
have negative impacts on economic growth, at least in the short run. According to one bank’s
estimates, for example, a Greek exit from the Eurozone would push output 7.5 percentage points
lower in 2011 than initially forecasted for Greece, and 1 percentage point lower for the other
Eurozone countries.52 Fourth, leaving the Eurozone would likely also strain the country’s political
relations with other countries in the European Union, and could possibly even lead to the country
having to depart from the EU.
Exit by One or More Northern European Countries
Another variant of the Eurozone-breaking-apart scenario is exit by one or more northern
European countries due to frustration with the current debt crisis.53 When the Eurozone was
created, there was concern among northern Eurozone members, particularly Germany, about the
50 Jack Ewing, “Merkel Urges Tougher Rules for Euro Zone,” New York Times, March 17, 2010.
51 Barry Eichengreen, “The Euro: Love It or Leave It?,” VoxEU, November 17, 2007,
http://www.voxeu.org/index.php?q=node/729.
52 Mark Cliffe, Maarten Leen, and Peter Vanden Houte, et al., EMU Break-up: Quantifying the Unthinkable, ING
Financial Markets Research, June 7, 2010, p. 8.
53 Gerard Baker, “Will Germany Leave the Euro?,” The Spectator, June 19, 2010, pp. 14-15.
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commitment of the ECB to price stability and the commitment of the southern European countries
to sustainable debt levels. Northern European countries did not want to be a “fiscal backstop” for
the southern European countries.54 To address these concerns, the ECB was created with the
primary goal of price stability (compared, for example, to the U.S. Federal Reserve, which has a
dual mandate of price stability and full employment), the legal text establishing the euro included
a “no bail-out” clause, and limits were put in place on the governments’ overall outstanding debt
levels (60% of GDP) and annual budget deficits (3% of GDP).
However, the current debt crisis has thrown these commitments into question. Some have argued
that the ECB’s decision to buy Eurozone public debt represents a loss of independence for the
central bank, and political support in some of the northern Eurozone countries for the financial
assistance package for the vulnerable Eurozone countries has, at times, been ambivalent at best.
Some have suggested that one or more northern European countries could exit the Eurozone in
favor of a new national currency. In Germany, four academics are actively trying to challenge the
constitutionality of Germany’s membership in the Eurozone in German courts.55
Even if reverting to a new national currency could regain northern European countries greater
control over their monetary policy and reduce their financial commitments to the southern
European countries, leaving the Eurozone could be costly. A new national currency for one of the
northern European countries would likely appreciate against the euro, complicating the export-led
growth strategies that several northern European countries pursue. The northern Eurozone
countries would also face the same technical, legal, and political challenges to exiting the euro
that face the southern Eurozone countries, discussed above. However, some observers believe that
banks in northern European countries, even with new national currencies, could still accept debt
payments in euros from southern European countries without posing a risk to their solvency.56
This scenario would also have significant repercussions for the EU and the future of European
integration.
Scenario 2. The Eurozone Survives
A second possible scenario is that the Eurozone emerges from the crisis largely in its current
form. The status quo in the Eurozone could be maintained if market pressures on vulnerable
southern European countries are calmed by the magnitude of the financial assistance package, the
ECB’s pledge to buy Eurozone public debt, and the introduction of new austerity packages in the
southern Eurozone countries. The austerity and structural reforms could also successfully lower
prices in southern European countries, reducing imbalances within the Eurozone and obviating
the need for additional integration of fiscal policies at the Eurozone level. Some argue that the
Eurozone could even survive a Greek debt restructuring, which some market participants believe
is inevitable.57 They argue that the financial assistance from the IMF and the other Eurozone
member states will allow the restructuring to be delayed for a few years, when markets may be
calmer and growth has been restored in other Eurozone member states. This could allow the
54 Ibid.
55 Wolgang Proissi, “Why Germany Fell Out of Love with Europe,” Brueghel Essay and Lecture Series, July 2020,
pp.15-17.
56At the same time, the value of northern banks’ euro-denominated assets would still fall relative to their liabilities
denominated in new currency.
57 Peter Boockvar, “Greece Will Have To Restructure: Equity Strategist,” CNBC, June 28, 2010.
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restructuring to be carried out in an orderly fashion that would not risk speculation against other
Eurozone countries and could allow Greece to remain in the Eurozone.
Some have expressed concern that if the Eurozone does emerge from the crisis in its current form,
the underlying problems with the architecture of the Eurozone that led to the current crisis would
not be addressed. In this view, failure to address these issues, including coordination of fiscal
policies at the European level and correction of the imbalances within the Eurozone that
developed over the past 10 years, may mean that similar crises lie ahead. On the other hand,
several financially vulnerable European countries, including Greece, Ireland, and Spain, have
recently held successful bond offerings, suggesting that the crisis may be stabilizing. This might
also be viewed as an indication that this second scenario, the Eurozone survives in its current
form, may be a likely outcome.
The new institutional arrangements being proposed clearly fall short of a fiscal or political union
that many economists believe is necessary to keep the currency union together, whether they will
be sufficient to strengthen the euro area remains uncertain. Much could depend on whether
financial markets have confidence in the soundness of the reforms implemented or whether
markets are left wondering if reforms will lead to more sustainable fiscal positions. Perceptions
on whether the Eurozone will be able to handle the next crisis more efficiently could determine
the long-term survival of the EMU. Little support exists in Europe for proposals that would imply
a significant transfer of spending and taxing powers to a central EU government and parliament.
Today, the EU budget represents about 1% of EU GDP and proposals to boost that by even 0.1%
consistently draw vetoes from several EU members.
Scenario 3. The Eurozone Becomes More Integrated
A third possible scenario is that substantial reforms to the Eurozone architecture are implemented,
leading to greater economic and political integration. This scenario would entail implementing
reforms to reduce fiscal free-riding and to enhance the ability of the Eurozone to respond to future
crises, if and when they arise. Greater fiscal federalism and a clear mechanism to provide
emergency financial assistance to vulnerable countries would also be a goal. Several proposals, as
discussed in the previous section, are currently being developed and are under consideration that
are intended to accomplish these goals, including review of national budgets at the European
level, more stringent enforcement of the restrictions on debt and deficit levels under the Stability
and Growth Pact (such as automatic enforcement of financial sanctions or revoking voting rights
of member states in violation of the Stability and Growth Pact), and establishing a permanent
fund to provide financial assistance to Eurozone members experiencing balance of payment
problems.
To date, proposals are still in the early stages. Control over fiscal policies remains at the national
level and financial assistance to Eurozone members is being made available on a temporary (three
year) basis. Fiscal policies are an important issue of national sovereignty, and it remains to be
seen whether, or to what extent, national governments in the Eurozone will be willing to concede
control over national budgets to European authorities. Also, given the unpopularity of the
financial assistance package for Greece and the broader support mechanisms for vulnerable
Eurozone members with voters in northern European countries, it is unclear whether countries
will be willing to commit, on a permanent basis, to providing financial assistance to Eurozone
members in crisis.
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Some observers argue for the creation of a solid framework for crisis resolution and an ability to
deal with sovereign default by a member state. In this view, the principle that a member state
cannot fail may imply a political or fiscal union to underpin the euro.58 These observers might
also argue that the EU should be able to issue sovereign debt. It is unclear, however, whether
there is political will to do that.59
Implications for U.S. Interests
Europe’s response to the Eurozone crisis may affect U.S. economic and political interests in
important ways. The Obama Administration, the Federal Reserve, and Congress have been
engaged in monitoring and working towards an orderly resolution of the crisis. Initially, a major
U.S. concern was that a sovereign default by Greece could have risked another wave of credit
freeze-ups, instability in the European banking sector, and spill-over to U.S. and global financial
markets. Currently, concern is centered on how slower growth and a weaker euro may affect the
U.S. economy, as well as how the evolution of the currency union may affect U.S.-EU economic
and political ties.
Economic Implications
Given the tightening of fiscal policies throughout the Eurozone in response to the crisis, some
economists are predicting a continuing decline in the value of the euro vis-à-vis the dollar and
slower growth over the next few years.60 Over time, a stronger dollar relative to the euro would
likely translate into an increase in the U.S. trade deficit with the Eurozone as European exports
become cheaper and U.S. exports become more expensive. A larger U.S. trade deficit with the
Eurozone, combined with expected increased in U.S. trade deficits with China and other Asian
countries, could increase the U.S. current account deficit beyond its previous record of $800
billion in 2006.
To maintain its economic recovery under these circumstances, the United States again may have
to become the consumer and borrower of last resort (by running large budget deficits with debt-
financed consumption sustained or facilitated by huge inflows of foreign purchases of Treasury
bills, thereby facilitating low interest rates). Under this scenario, the strategy for global
rebalancing of production and consumption agreed to by the Group of 20 at its last few meetings
might not be realized and protectionist pressures in the United States, with unemployment
remaining high, could rise.61 Low interest rates could, at the same time, facilitate Treasury
Department efforts to finance high U.S. debt levels.
A weaker euro would also likely have some effects on U.S.-Eurozone foreign direct investment
flows. Currently, Eurozone countries account for 26% of all U.S. direct investment abroad and for
44% of all foreign direct investment in the United States. Based on slower projected growth rates
58 Daniel Gros, “Are the Barbarians a the EU’s Gates?” Europeanvoice.com, May 25, 2010.
59 Zsolt Darvas, “Fiscal Federalism in Crisis: Lessons for Europe from the US,” Bruegel Policy Contribution, Issue
2010/07, July 2010.
60 The euro, for example, has depreciated by 15% against the dollar between December 12, 2009 and August 13, 2010
(from 1.51 $/€ to 1.28$/€).
61 Fred Bergsten, “New Imbalances Will Threaten Global Recovery,” Financial Times, June 10, 2010.
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in Europe, U.S. investors may look towards emerging markets for additional investments,
particularly since profits generated in euros would translate into fewer dollars, hurting the bottom
line of U.S. parent companies. An offsetting factor could be that European stocks and assets with
a weaker euro would look cheaper and more attractive, particularly given that the average
European stock currently sells for ten times estimated 2010 earnings -- the lowest valuations
based on expected earnings since the 1980s and at a level that is 25% less than the average of
U.S. stocks.62
The economic impact could be much more substantial if the Eurozone were to break-up or
splinter due to a deepening sovereign debt crisis. By one estimate, a complete break-up of the
Eurozone could lead to a 10% cumulative loss of output over the first two years.63 Combined with
a likely adverse impact on the functioning of the EU’s single market, U.S. exports of goods,
services, and investment to Europe (which totaled over $1.5 billion in 2008) could be
significantly reduced. Moreover, such a development could also weaken heavily-exposed
European banks, particularly French and German banks, and precipitate another global financial
crisis.64
At the same time, it is also possible that current difficulties the U.S. economy is facing—slower
than expected economic growth and high unemployment—could combine with a better than
expected growth performance in Europe to dilute the pressures for a weaker euro. The Eurozone
economy, for example, grew faster than the U.S. economy (1% compared to 0.4%) in the second
quarter of this year.65 Given that many different factors affect relative exchange rates, predictions
of long-term changes are often inaccurate.
Political Implications
Over the years, a key U.S. political interest has been a prosperous, peaceful and stable Europe. In
support of this interest, successive U.S. administrations have supported European efforts at
economic and political integration. U.S. policy on the euro and the EMU has generally been that
if it is good for Europe, it will be good for the United States. For example, on January 4, 1999,
then President Clinton issued the following statement:66
We welcome the launch of the Euro, an historic step that 11 nations have taken toward a
more complete Economic and Monetary Union (EMU). The United States has long
advocated for European integration, and we admire the steady progress that Europe has
demonstrated in taking the often difficult budget decisions that make this union possible. A
strong and stable Europe, with open markets and robust growth, is good for America and
good for the world. A successful economic union that contributes to a dynamic Europe is
clearly in our long-term interests.
Given this history, if the Eurozone emerges from the crisis close to its present form or even
stronger than before, strong U.S.-EU political ties are likely to continue. Only in the possible
62 Jeremy J. Siegel, “Upside of the Euro Crisis,” Kiplinger’s Personal Finance, July 5. 2010.
63 ING Global Economics, “EMU Break-up: Quantifying the Unthinkable,” July 7, 2010.
64 Desmond Lachman, “Euro Will Unravel, and Soon,” American Enterprise Institute for Public Policy Research, No.
2, September 2010.
65 BBC Business News, “Eurozone growth of 1% confirmed,” September 2, 2010.
66 Website: [http://clinton6.nara.gov/1999/01/1999-01-04-statement-by-the-president-on-the-launch-of-the-euro.html]
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scenario of the Eurozone breaking apart are the effects likely to raise questions about the status
quo. Major challenges to political ties could emerge if a break-up of the Eurozone were
accompanied by growing divisions between key European countries, economic and social turmoil
in selected countries, or a return to more nationalistic policies. The Obama Administration, like
previous administrations, believes that a prosperous, secure, and increasingly integrated Europe
that is capable of partnering with the United States in addressing mutual policy challenges is in
the U.S. interest. On the other hand, it might also be argued that if a break-up were to occur, the
United States might have greater influence with individual members of the EU. Those who held
this view might also argue that a break-up could make the EU less of a rival to the United States.
Concluding Observations
The Eurozone crisis has highlighted cracks in the architecture of the currency union. Efforts to
make the currency union more stable and sustainable in the long run represent one of the most
fundamental challenges European leaders have faced in an over 50-year effort to advance political
and economic integration. The U.S. stake in the outcome of these efforts, given the magnitude of
U.S. economic and political ties with Europe, is considerable.
European proposals to date to reform the currency union center heavily on increasing fiscal
coordination and integration in ways that do not surrender members’ autonomy to make their own
spending and tax decisions to a supra-EU entity. Rather, the proposals seek to strengthen current
Stability and Growth Pact rules, partly through some form of sanctions, and to provide more
policy coordination on budgets and other fiscal matters. Backed by the creation of liquidity
facilities and the continued active involvement of the ECB in crisis management, European
leaders may have a limited period of time to calm financial markets and bolster confidence in the
currency union.
Whether the currently contemplated reforms prove sufficient to ensure the sustainability and
viability of the currency union is unclear. A number of factors and developments could either
bolster or destabilize the currency union in the years ahead.
Factors and developments that could bolster the Eurozone include the following:
• Given that the EMU is largely a political undertaking and a major symbol of European
integration, European leaders and elites may be highly motivated to keep the EMU intact.
• The proposals under consideration introduce institutions and policies that represent
somewhat higher levels of integration and commitment to budgetary discipline—
elements that are considered necessary to rebuild market confidence in the euro for the
future.
• The creation of the European Stability Mechanism (ESM) to replace the EFSF after 2013
provides a permanent facility to ensure fiscal and financial stability in the Eurozone.
• The ECB has demonstrated willingness to help members in fiscal distress, and it has the
tools to continue playing an active role in crisis management.
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• The rescue program put into place basically overturned the “no-bailout” rule of the EMU,
making states, at least in theory, mutually liable for the sovereign debt of fellow
Eurozone members.
• The acceptance by European policymakers of IMF involvement in managing any future
fiscal crises reinforces the fiscal insurance mechanism provided by the EFSF.
• Proposed reforms of labor and product markets in all Eurozone countries, combined with
stronger fiscal discipline, will improve the potential for economic growth and strengthen
the euro in the long run.
Factors and possible developments that could weaken the sustainability of the currency union in
its current form include the following:
• Partial solutions proposed to date create a moral hazard; if heavily indebted countries
think they will receive financial assistance from the EFSF, they may have few incentives
to get their fiscal houses in order.
• A default or rescheduling of Greek, Irish, or Portuguese debt, which many analysts
maintain is possible, could pose contagion effects on other highly-indebted Eurozone
countries.
• In the event of a possible sovereign default or defaults by Eurozone members, public
support in some of the Eurozone members for continued funding of the EFSF could
decline.
• Fiscal measures and shared responsibility for defaults could lead to divisions among
Eurozone members, causing some members to reconsider the costs and benefits of
membership.
• Persistent current account imbalances within the Eurozone, perhaps even more than the
build-up of debt, can over the long-term become a challenge to the future stability of the
Eurozone.
• The problem of current account imbalances may be complicated in the future by the
proposed entry of mostly smaller and poorer countries into the EMU.
• Greater labor mobility and wage flexibility may not prevent the accumulation of
persistent economic imbalances that led to the crisis and threaten the existence of the
EMU.
• The fundamental problem of countries at very different levels of development living with
a single monetary policy and a single exchange rate will remain.
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Table 3. Glossary of Terms
Term Definition
Broad Economic Policy
The Broad Economic Policy Guidelines (BEPGs) are adopted by the Council as a
Guidelines (BEPG)
reference document guiding the conduct of the whole range of economic
policies in the Member States and the European Union. They play a central role
in the system of economic policy coordination, setting out economic policy
recommendations which give a basis for economic policy in both the Member
States and the EU as a whole in the current year.
Council of the European
The Council of the European Union is the Union’s main decision-making body and
Union (“Council of
enacts legislation based on proposals from the European Commission. Its
Ministers” or “Council”)
meetings are attended by the member state ministers, and is thus the institution
which represents the member states. The Presidency of the Council rotates
among the member states every six months.
Economic and Monetary
Economic and Monetary Union (EMU) is the process of harmonizing the economic
Union (EMU)
and monetary policies of the member states of the European Union with a view
to the introduction of a single currency, the euro.
European Central Bank
Founded on June 30, 1998, the European Central Bank (ECB) is the institution of
(ECB)
the European Union responsible for setting the monetary policy of the 16 EU
member states taking part in the Eurozone. The bank is headquartered in
Frankfurt, Germany.
European Commission (EC)
The European Commission (EC) acts as the EU’s executive branch, and has the
right of legislative initiative. There are 27 Commissioners—one from each
country.
European Council
The European Council brings together the leaders of the member states and the
Commission President. It acts as a strategic guide and driving force for EU
policy.
European Financial Stability
The European Financial Stability Facility (EFSF) was set up by the 16 Eurozone
Facility (EFSF)
countries to provide a funding backstop should a euro area Member State find
itself in financial difficulties. The EFSF has the capacity to issue bonds guaranteed
by euro area members for up to € 440 billion in lending to Eurozone countries.
European Financial Stability
The European Financial Stability Mechanism (EFSM) is a new €60 billion
Mechanism (EFSM)
supranational EU balance of payments loan facility available to any EU member
country facing financial difficulties.
The European System of
The European System of Central Banks (ESCB) comprises the European Central
Central Banks (ESCB)
Bank and the national central banks of al EU member states whether they have
adopted the euro or not.
European Union (EU)
The European Union (EU) was established by the Treaty on European Union
(Maastricht, 1992). The project of creating a Union has a long history, and was
first mooted at the European Summit of 1972. The Union is both a political
project and a form of legal organization.
Eurozone
The Eurozone, officially the euro area, is an economic and monetary union (EMU)
of 16 EU members states which have adopted the euro currency as their sole
legal tender. Monetary policy of the zone is the sole responsibility of the
European Central Bank, though there is no common representation, governance
or fiscal policy for the currency union. Some cooperation does, however, take
place through the euro group, which makes political decisions regarding the
Eurozone and the euro.
Excessive Deficit Procedure
The excessive deficit procedure is governed by Article 104 of the Treaty
(EDP)
establishing the European Community, under which member states are obliged
to avoid excessive deficits in national budgets.
Lisbon Treaty
The Lisbon Treaty, the latest institutional reform treaty of the European Union
(EU), went into effect on December 1, 2009. It seeks to give the EU a stronger
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Term Definition
and more coherent voice with the creation of a new position, President of the
European Council. It also makes changes to the EU's internal decision-making
mechanisms, and foreign policy apparatus, among other provisions.
Maastricht Treaty
The Treaty of Maastricht, formally, the Treaty on European Union (TEU), was signed
on February 7, 1992 by members of the European Community in Maastricht,
Netherlands. Upon its entry into force on November 1, 1993, it created the
European Union and led to the creation of the single European currency, the
euro.
Sovereign debt
Sovereign debt is a financial liability of a national government.
Stability and Growth Pact
The Stability and Growth Pact (SGP) pertains to the third stage of economic and
(SGP)
monetary union (EMU), which began on January 1,1999. It is intended to ensure
that member states maintain budgetary discipline after the single currency has
been introduced.
Source: Europa Glossary (http://europa.eu/scadplus/glossary/index-en.html).
Author Contact Information
Raymond J. Ahearn, Coordinator
Rebecca M. Nelson
Specialist in International Trade and Finance
Analyst in International Trade and Finance
rahearn@crs.loc.gov, 7-7629
rnelson@crs.loc.gov, 7-6819
James K. Jackson
Martin A. Weiss
Specialist in International Trade and Finance
Specialist in International Trade and Finance
jjackson@crs.loc.gov, 7-7751
mweiss@crs.loc.gov, 7-5407
Acknowledgments
The authors wish to thank the following CRS colleagues who provided helpful suggestions and comments
on this report: Paul Belkin, Nils Bjorksten, William Cooper, Ian Fergusson, Marc Labonte, Derek Mix, and
Dick Nanto.
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