Seminar 10: The Eurozone Crisis (a)


In 2008, the Eurozone experienced a sovereign debt crisis. Public debt now averages around one year of national income in most member-states (approximately 90 per cent of GDP). But this varies significantly between countries.


Most of the increase in national public debt, since 2008, was an outcome of “bailing out” the private financial sector, and collapsed revenues associated with declining economic growth.

The EMU, as discussed in previous seminars, was created as a single currency without a state. It is not a federal fiscal or budgetary union capable of absorbing asymmetric shocks.

The cost of the collapse in the banking sector, such as in Ireland, is paid by national taxpayers not the federal currency union. Banks are global in life but national in death.

The origins of the crisis 

What are the origins of the Eurozone crisis? They can be traced to both domestic and international factors.

From 1999, all EMU member-states transferred monetary sovereignty to the European Central Bank (ECB). This was created as the most independent central bank in the world and modelled on the tradition of the German Bundesbank.

The ECB has interpreted its primary mandate as price stability, not economic growth, maximizing employment or financial market stability.

Up until 2008, everything seemed fine. Interest rates converged. Households, firms and governments could borrow cheaply. This convergence in financial markets was assumed to equal economic and political convergence.

But the institutional foundations of national economies continued to diverge. Portugal did not become Austria. This would not be a problem in a federal union i.e. between California and Delaware. But it is a problem in the EMU.

Capital flowed from the core to the periphery fueling asset price bubbles in Spain and Ireland, for example. When this capital flow when into reverse, countries got into trouble.

The imbalance of capitalisms 

One way to observe the divergence between creditor and debtor countries (core and periphery) is to examine the current and capital account within the Euro area.

Up until 2008, most trade was internal to the Euro area, a semi-closed trading bloc.

Current account

Source: Johnston & Regan (2016)

These macroeconomic indicators, which have shaped the post-crisis European economic governance regime, are generally used to illustrate the difference in cost competitiveness between countries.

Angela Merkel famously carried a graph of the divergence in unit labour costs (ULCs) into EU Council meetings, which are then used as an indicator that the south of Europe needs to become ‘competitive’ i.e. reduce wages.

What current account imbalances really illustrate is the divergence in national models of capitalism, or growth regimes, within the Euro area: consumption and export-led.

Can countries converge on an export-led growth model?

Losing tools of adjustment 

Prior to the monetary union, these different models could co-exist because each member-state had access to those macroeconomic tools to adjust their economies when confronted with an economic shocks. This is no longer the case.

Monetary policy is Europeanised whilst fiscal policy is deeply constrained by the rules of the Maastricht treaty, and the fiscal compact treaty.

Countries are forced to ‘compete’ with each other via other mechanisms i.e. reducing wages and lowering taxes.

In agreeing to join the EMU, all member-states agreed to follow two strict ‘Maastricht rules’ that stipulate they cannot have a public-debt to GDP ratio of more than 60 per cent or budget-fiscal deficits that exceed 3 per cent.

These rules were first broken by Germany, then France, Italy and Greece.

Other than these fiscal rules the EMU did not generate the problem-solving capacity to deal with asymmetric economic shocks.

It is not an ‘optimal currency area’. It was an unprecedented political experiment in international regional cooperation: creating a currency union without a social state.

No lender of last resort 

The fragility of the EMU was radically exposed in 2008.

When the US subprime mortgage crisis spread to Europe, regional banks collapsed, capital flows went into reverse, economic growth declined and government revenue plummeted.

In the absence of a central bank capable of acting as a lender of last resort, financial markets panicked.

The interest rate on government bond yields shot up. Peripheral member-states of the Euro area were priced out of the markets.

Interest rates

Those countries priced out of the market had to seek financial assistance from the Troika (ECB, IMF, EU Commission), who issued loans with strict conditionalities attached.

The most important point to observe, however, is that the sovereign debt crisis in the euro area was a consequence not a cause of the financial crisis.

It could have been avoided if the ECB had the capacity to act as a lender of last resort. But the ECB does not have this mandate.

The ECB eventually saved the currency when the new President, Mario Draghi, issued a press release, signaling that he would “do all that is necessary to save the Euro”.

Who pays?

The question of who pays for this financial-banking collapse in the EMU reveals the tense relationship between capitalism and democracy, markets and citizens, investors and taxpayers.

It also reveals the limitations of the nation-state in governing global markets.

There are three ways this sovereign debt in Europe can now be reduced:

  • taxes on capital
  • inflation
  • austerity


Inflation was, historically, how nation-states dealt with public debt. In Europe today, the strategy is fiscal consolidation (austerity) and internal devaluation.

But what exactly does this mean?

In effect, it means that the only way to pay off public debt is to increase export-led growth. But absent monetary and fiscal tools, growth can only come from improved competitiveness, this is assumed to equal reduced labour costs.

The presentation we looked at last week by Mario Draghi captures the core policy strategy of the Euro area.

European governments, such as Ireland, could reduce all public debt by privatizing all public assets. This means the government would pay rent to those who own schools, hospitals and police stations rather than pay interest to fund them.

This is obviously not going to happen.

Capital taxes 

Thomas Piketty calls for a progressive private capital/wealth tax as a means to reduce public debt. What are the advantages/disadvantages of this fiscal solution?

A progressive tax on European capital-wealth (not just bank deposits but all assets including shares) at a rate of 0 per cent on up to 1 million, 10 percent between 1 and 5 million, and 20 percent above 5 million would reduce public debt by 20 percent of GDP.

Alternatively, the same rates of 0, 1, and 2 percent over 10 years would yield the same result.

The important point to be observed is that different economic choices have different distributional implications. In distributing the burden of adjustment for the banking collapse, governments have decided to not tax capital-wealth.

Rather, the strategy is to increase labour-income taxes, and reduce public expenditure. But do governments really have a choice? Are alternative adjustment paths possible?


Why do democratic governments not tax capital to deal with the public debt crisis, as suggested by Piketty?

Think about the importance of ideas, interests and institutions in shaping the political economy of adjustment.

First, capital taxes directly contradict the general intellectual paradigm underpinning European integration. Second, the interests and influence of those with wealth are politically opposed to this.

Thirdly, and perhaps most importantly in the context of EMU, it would require cross-national coordination among governments: it would require giving up more fiscal sovereignty, which the electorate don’t want.

The capacity of the nation-state to solve economic problems is clashing with the realities of global financial markets.

What about inflation as a strategy to reduce public debt?

An inflation rate of 5 percent per annum would allow governments to reduce their debt by more than 15 percent. It was this type of inflation that allowed Germany to embark on its post-war reconstruction without creating a sovereign debt crisis (in addition to massive financial assistance from the USA).


If there is no inflation, and no tax on capital, and a growth rate of 2 percent per annum, then the only choice is to cut spending and wages. But this austere strategy will take Euro governments over 20 years to reduce their debt to GDP ratio by 20 percentage points.

For example, at present, the Irish government spends more on debt interest re-payment as a percent of GDP than it does on its universities. Public debt is another persons private wealth. It is a form of redistribution.

European countries are rich, wealth and capital-income ratios are at their highest since the 19th century. This is not the case for governments who must rely on debt or taxes to finance public expenditure.

Nobody wants to pay more tax, neither the rich nor the poor. Member-states in the Euro do not want to pool their debt or deficits. There is no ‘technical’ solution to these distributive dilemmas. It is a political problem.

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