Institutional Failure and the Euro Crisis
By: Sophie Milner
Tags: Policy, Instiutions, Euro Crisis, Economy, Greece

In less than a decade, the concept of the euro has progressed from the drawing board to a tangible currency. Implemented with the intention of creating economic and political prosperity, the merging of markets into the single currency boasts both a remarkable and unprecedented history (Aizenman 2014). Regarded as incomplete since inception, this union attempts to encompass varied economic traditions, policies, institutions, and interests (Hope, Iverson & Soskice 2016). Two distinctly different worlds — divided into core and periphery countries — currently struggle to co-exist. Their divergent growth paths foster a sense of ‘destabilising macroeconomic imbalances’ which exacerbate the ongoing public debt crisis (Dahan 2015). Paired with insufficient government architecture regarding the Economic and Monetary Union (EMU), the Eurozone has been left with a problematic and asymmetrical means of adapting to the crisis (Dallago & Guglielmetti2011). As this essay will argue, characterising Europe’s financial turmoil as merely a sovereign debt crisis overlooks these inherited structural imbalances, despite the centrality of institutional and policy failures to the Euro Crisis. Specifically, distorted fiscal policy, the fragmented supervision of banks, and the limited mobility and flexibility of labor markets are major problems stemming from the Eurozone’s institutional structures. This essay will unpack and discuss these core issues contributing to the Euro Crisis, detailing their ongoing role in shaping prospects of integration.

The Eurozone is comprised of nineteen independent nation-states, which, in theory, can de facto and leave the currency at any time. Its origins can be attributed to national economic interests, rather than those emerging from a federal political standpoint (Hope, Iverson & Soskice 2016). The Schuman Declaration of May 1950 proclaimed the zone as the world’s first supranational institution. The basic features of this modern Europe included: economic and commercial integration of financial resources; a common fiscal parameter; a single, unified currency; open financial markets; and unintegrated labour markets (Dallago & Guglielmetti 2011). Despite intentions of fostering systematic resilience through an expanded market and financial discipline, this formation of a ‘partially sovereign transnational organisation’ exists in an idealistically incorrect position (Razin & Rosefielde 2012). A common currency requires unified nations to share the same policies, basic interest rate, and exchange rate. However, significant asymmetries in the organisation of political economies separate the core countries of Germany, Belgium, Austria, Finland, and the Netherlands, from the periphery countries of Spain, Portugal, Greece, Ireland, and Italy. Whilst the economies of the former nations are institutionally prepared to operate an export-led growth strategy, those of the latter lack the institutional capacity to do so. Consequently, their exports are heavily impacted by low-cost competition from core countries (Hall 2015). Furthermore, this supranational institutional dilemma reflects a sub-optimal economic and monetary union — essentially laying the groundwork for the Euro Crisis (Feldstein 2012).

Seven of the Eurozone’s nineteen nation-states have been crippled by the financial crisis throughout the last decade. Following the rise of private and public debt, coupled with the downgrading of government debt, investors grew fearful of a sovereign debt crisis in late 2009. With numerous countries facing the transferal of property debt to sovereign debt due to the bailout of banking systems, investors’ concerns of a slowing economy became reality (Bennassy-Quere & Boone 2012). Article 121(1) of the Maastricht Treaty of 1992, which is responsible for the formation of the euro, requires all members to adopt the currency. This convergence criteria states that, “…the ratio of the rate of growth of annual government debt to GDP must not exceed 3%… (and) the ratio of government debt to GDP must not exceed 60%” (Nowak & Shachmurove 2012 p. 8). Furthermore, had certain nations adhered to this treaty, the ongoing crisis may have been avoided. Using Greece as an example, forcing the country to comply with the Maastricht criterion would have prevented them from joining the union. However, the appeal of increased reliability and efficiency, an enhanced investment grade, and heightened prospects for foreign capital inflow, paired with a clause allowing for temporary violation of the treaty, Greece’s membership of the Eurozone was inevitable (Bozani & Drydakis 2015).

The ongoing financial hardship faced by the Eurozone can also be attributed to American actions, with the Global Financial Crisis of 2007 instantaneously affecting this region. At this time, the Eurozone’s economic bubble was close to bursting; several nation-states were financially deregulated, experiencing rapidly expanding credit, and indulging in excessive deficit spending. The subsequent burst of this bubble revealed significant differences in the plight faced by Europe and the United States — no similar counterparts of Portugal, Italy, Ireland, Greece or Spain existed in the latter. Therefore, although some of the American states overborrowed, their sovereign debt did not expose them to deflationary risk or threaten their sense of federal unity (Razin & Rosefielde 2012). The Eurozone became crippled by the continuous rise of both public and private debt, with its people coming to the realisation that a unified currency without a unified state was unsustainable. Greece’s political class, now enlightened to the true scope of the financial crisis, slowly began to act. Despite remaining, “…the most vulnerable link of the euro chain,” this nation became, “…the catalyst for the transition into (a) new phase” (Tsoukalis 2013 p. 26). The response of its fellow member-states eventually shifted from outright denial, to hesitant acceptance of a national solution. However, implementation took several months due to the complete lack of provisions for sovereign insolvency within the Maastricht Treaty. Its authors believed doing so would destabilise the union as bonds would require dissemination within the already integrated system. Ultimately, the Eurozone was forced to bypass the criteria and provide loans to Greece. In 2010, further mechanisms were developed to aid other nation-states in trouble, with such rescue packages extended to Ireland and Portugal (Bennassy-Quere & Boone 2012). This failure to establish a coherent framework consistent with the Eurozone’s existing institutions is simply not viable in the long-term.

Fiscal dilemmas imbedded in the Eurozone’s institutions are often attributed to the scale and severity of its crisis. Its origins are regarded to be found, “…in the Eurozone construction itself — a monetary union with no fiscal federalism and weak government coordination” (Bennassy-Quere & Boone 2012 p. 1). This lack of coordination, originally designed to allow individual nations to pursue their own political and financial agendas, rather compromises the visibility of the region’s currency, and its economy as a whole (Feldstein 2012). Several nation-states’ failure to abide by the Stability and Growth Pact (SGP), developed to foster fiscal sustainability through binding regulations and financial restrictions, led to higher interest rates and declining exchange rates. With market signals acting as warnings for countries to reduce borrowing, fiscal transfers function as a mode of insurance (Skaperdas 2011). For example, when the United States is in a state of financial turmoil, automatic transfers from the federal government shield the economy from complete devastation. Contrastingly, such a transfer is not feasible in the EMU — primarily due to their politically weak institutions (Razin & Rosefielde 2012). The, “…grouping of independent sovereign states with differentiated institutional systems,” has ultimately caused a, “…striking discrepancy between widely accepted views of the institutional desiderata of a common currency area” (Hope, Iverson & Soskice 2016 p. 168). In this sense, the conflicting growth strategies and levels of wealth, in combination with voters’ anxieties of losing their sense of sovereignty due to burden sharing, the advancement of supranational institutions has been severely limited (Hope, Iverson & Soskice 2016).

This poor implementation of fiscal policy will be considered with a focus on Greece. As discussed earlier, the prospects of obtaining credit at reduced interest rates encouraged Greece to join the union; however, increased national borrowing exacerbated their total debt. Additionally, with socialist leaders attempting to improve living standards of the lower class through wage increases, the nation continued to spend significantly more than what was being earnt. Despite warnings, Greece continued to bury itself further in debt. Following the downgrading of credit in 2009, the lack of sufficient fiscal policy deeply affected the nation. Emerging from a lack of revenue, these fiscal problems are a result of systematic tax evasion, with, “…self-employed, wealthier workers tend(ing) to under-report income while over-reporting debt payments” (Johnston 2020). As of 2011, Greece’s social spending expenditures were 23.5% of the GDP — well below the Eurozone’s average of 24.9%.

Fearing the same for neighbouring debt-ridden member-states, the Eurozone provided Greece with a $110 billion bailout package. Although overspending and fiscal irresponsibly clearly affects the EMU in its entirety, promises for reform and reduced government spending continue to be opposed by unions through striking workers (Gutierrez 2013). In 2016, Greek hospital doctors, municipality workers and school teachers joined a nationwide strike called by the main public sector union ADEDY, and ships remained docked for 24-hours as part of a separate walkout called by seamen. With ADEDY stating, “workers and the poor are always the ones to pay the costs of crisis,” the state asset sales and labour reforms exchanged for bailout loans by the government were protested (Koutantou & Maltezou 2016).

The fragmented supervision and ambiguous responsibilities of the Eurozone’s banking system is regarded as yet another institutional flaw. Specifically, the lack of credible lenders in government bond markets, and a distinct banking union are attributed to the scale of the Euro Crisis. The devastation of public finances in Spain, Ireland and Portugal had the potential to be reduced if burden sharing between cross-border banks, encouraged through a formal union, had been employed. In practice, a bank chartered in Ireland may receive funds from German or French banks — thus, the question of the default guarantor of deposits and other liabilities being solely of the Irish state is posed. In a common currency area such as the Eurozone, the promotion of free capital movements to foster equal opportunities between banks simply does not allow for, “…the individual states of origin of the bank to be solely responsible for their supervision and deposit insurance, and be the ultimate bagholder of its liabilities” (Skaperdas 2011 p. 13). Ensuring the efficient allocation of capital stock, transaction and intermediation services, and funding for new businesses and technology, the banking system, in theory, should, “…provide the fulcrum around which the economy turns” (Kennedy & O’Sullivan p. 226).

The liberalised regulatory banking system of the Eurozone rather contributed to the worst financial crisis Ireland has experienced to-date. In 2008, increasing credit essentially crashed the property market — the subsequent decline in house prices gave rise to credit defaults in banks’ now property-exposed loan books. Paired with the freezing of international money markets, Ireland’s banks faced extreme difficulties in terms of funding. The blanket guarantee of debt obligations, and nationalisation of their third largest bank were the controversial means of which the Irish government employed to rescue the system (Kennedy & O’Sullivan p. 3). The lack of recognition by both political and economic elites in regards to these institutional discrepancies is reflected by the absence of reform, and the reaction to the Irish crisis. Additionally, the inability of the European Central Bank (ECB) to be a credible lender during the beginning of the Euro Crisis exacerbated default fears as bond yields in Greece increased. Due to the design of the Eurozone, governments in trouble lacked a lender of last resort — thus, borrowing of the euro was similar to foreign currency debt. With the ECB explicitly forbidden from acting as such a lender, the intrinsic approach to avoiding default — engaging the central bank to print the money required to service the debt — was not possible (Baldwin & Giavazzi 2015). Its quasi-unilateral operation ensured the ECB remained the singular actor with the means of making decisions without member-states’ approval. Therefore, significant problems of instability crippled the operation of the Eurozone (Hope, Iverson & Soskice 2016).

The inability of the Eurozone’s institutions to fulfil conditions prescribed by an Optimal Currency Area (OCA), namely in regards to inflexible labour markets, is yet another intrinsic flaw. Globalisation has led to a steady progression toward flexibility across most of the advanced world, however labour markets in the EMU remain relatively unchanged. They are rather, “…far from flexible, with widespread collective bargaining, employment protection, and limited labour mobility” (Hope, Iverson & Soskice 2016 p. 167). Once again, through comparison to the United States, the blatant shortcomings of these institutions become evident. Although the size of the Eurozone’s population and economy is similar to that of the United States’, it lacks this country’s labour mobility across states, and congruent laws, cultures and politics. The EMU’s ability to adjust to shock is therefore severely limited (Skaperdas 2011). This absence of relevant institutions has led many economists to regard the Eurozone as, “…a failed experiment” (Hope, Iverson & Soskice 2016 p. 167). Despite initial warnings that divergence in economic competitiveness, labour market inflexibility, and an absent federal budget would impact the operation of the euro, the single currency was implemented. With the SGP acting as a means of budgetary integration, and other broad economic guidelines introduced to foster labour and product market flexibility, the Eurozone’s competitiveness was somewhat enhanced. Although the zone’s dual growth model operated successfully in the decade prior to the Euro Crisis, the omission of the conditions prescribed by an OCA’s institutions eventually exposed its weak and insufficient instruments (Hope, Iverson & Soskice 2016). The lax sanctions, lack of enforcement and incentives, and misguided surveillance, in combination with the SGP’s dependence on fees and peer pressure revealed notable limitations of these institutions (Bennassy-Quere & Boone 2012).

The implications of these issues to the Greece economy will once again be explored. Greece’s economy suffered from a 21% reduction in output between 2010 and 2013, with unemployment rising from 12.7% to 27.5% during the same period. The now 1.3 million citizens without work, paired with the necessity of dealing with labour market inefficiencies, led to significant reforms targeted at reducing labour costs (Kosma, Papapetrou, Pavlou, Tsochatzi & Zioutou 2017). In order to work effectively, these reforms require: complementary reforms in product market areas; polices centred on income re-distribution and aggregate demand stimulation; balancing both fairness and flexibility for employees and their employers; and consideration of the high unemployment rate (Bozani & Drydakis 2015). Furthermore, the Eurozone’s outdated institutions, specifically in terms of inflexible labour markets, has contributed to the severity of its financial crisis.

The short history of the Eurozone is both remarkable and unprecedented. Its attempt to encompass a range of traditions, institutions, interests and policies into a unified currency that fosters economic prosperity is widely regarded as incomplete, with divergent growth paths contributing to the zone’s ongoing public debt crisis (Dahan 2015). The interaction between institutional and policy failures are further contributors to this financial crisis, yet

insufficient government architecture emerging from the EMU leaves it ill-equipped to adapt. This essay has argued that characterising the Euro Crisis as merely sovereign financial turmoil fails to acknowledge these inherited structural imbalances. Through discussions of the core issues of distorted fiscal policy, the fragmented supervision of banks, and limited mobility of labour markets, the role of the Eurozone’s failing institutions in the crisis has been demonstrated.

References

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