The euro crisis: Muddling through, or on the way to a more perfect euro union?

Joshua Aizenman, 3 July 2014



The short history of the Eurozone has been remarkable and unprecedented – the euro project has moved from the planning board to a vibrant currency within less than ten years. Otmar Issing’s optimistic speech in 2006 reflects well the buoyant assessment of the first decade of the euro – an unprecedented formation of a new currency without a state.1 Observers viewed the rapid acceptance of the euro as a viable currency and the deeper financial integration of the Eurozone and the EU countries as stepping stones toward a stable and prosperous Europe. The growing current-account deficits of GIIPS (Greece, Ireland, Italy, Portugal, and Spain) in the early 2000s supported their growing borrowing at declining sovereign spreads. Intriguingly, GIIPS bonds’ interest rates dramatically converged during the 1990s to the German rate (see Figures 1 and 2). Observers viewed emerging Europe’s large current-account deficits as a validation of the gains associated with ‘capital flowing downhill’,2 possibly dispelling concerns about the limited benefits of importing foreign savings as a means of financing domestic growth.3 The celebratory assessment of the euro continued well into its tenth-year anniversary, only to crash with the unfolding events of the Eurozone crisis.

Figure 1. GIIPS and German government bond rates

Sources: ECB, Bloomberg,

Figure 2. GIIPS and German current account/GDP

Source: Gavyn Davies, Financial Times

German dominance of the Eurozone

In Aizenman (2014), I look at the short history of the Eurozone through the lens of an evolutionary approach to forming new institutions. This lens provides a useful perspective on the formation of global exchange-rate regimes, currency unions, and the like.4 It suggests that Issing’s optimism on “The euro as a currency without a state” overstates the evidence. At best, the euro is a currency without a state, under the dominance of Germany. This statement by itself may be good news – Cohen (1994) identified the presence of a dominant state “willing and able to use its influence to keep a currency union functioning effectively” as a key condition for the stability of a union.5 The growing dominance of Germany in the Eurozone suggests that it may meet Cohen’s condition. Yet, Germany would only stabilise the Eurozone as long as it does not shirk its growing responsibility for the euro’s future. This would require Germany to invest more in upgrading Eurozone institutions and balancing its dominance gains with the economic and political responsibilities that come with it.

The Eurozone crisis put an end to the euro honeymoon, bringing to the fore the key importance of Germany’s economic and political decisions in determining the Eurozone’s viability and future.6 The challenges associated with managing the growing fragility of the euro may induce a reluctant Germany to face an upcoming stark tradeoff – the vibrant growth of Germany, while running large current account surpluses under a pegged exchange rate with the other Eurozone countries, may come to an abrupt end if the Eurozone unravels.

Germany has not yet been exposed to the full costs of the macro straightjacket associated with the euro. The economic benefits of the Eurozone to Germany and GIIPS were initially frontloaded. Being a member of the Eurozone mitigated Germany’s real appreciation, in comparison with retaining the Deutsche Mark. For GIIPS, the availability of cheap borrowing at a time of growing optimism about the euro supported growing current-account deficits, and vibrant consumption and investment – which eventually contributed to unsustainable growth and real estate booms.

Similar to the experience of emerging markets that liberalised their financial systems in the 1990s under a fixed exchange rate, the increasing costs of the resultant balance-sheet exposures were below the radar screens of markets and policymakers – until an abrupt stop, which was followed by capital flight crises (Calvo 1998). This may reflect a fundamental problem with the pricing of sovereign risk in which the private sector, as the ‘interest rate taker’, overlooks the growing marginal impact of borrowing on sovereign risk (Aizenman 2004). This externality also holds under a flexible exchange rate, but has probably been magnified by the economic strength of the Eurozone core and by moral hazard – the presumption that the growing costs of unwinding the euro will induce bailouts down the road.7 The Eurozone crisis forced GIIPS countries to confront the costs of their excessive borrowing prior to the crisis, as it terminated their easy access to funding their current accounts and addressing their growing fiscal deficits.

The resilience of the German economy

In contrast, beyond the growing balance-sheet exposure of its financial system, Germany has not yet been fully exposed to the downside risk of higher unemployment and lower growth that has already hit most of the Eurozone countries. The resilience of the German economy probably reflects:

  • The advantage of running a sizeable current account surplus under a fixed exchange rate with its Eurozone counterparts,
  • The relative efficiency of the German labour market, and
  • The country’s specialisation in exporting advanced manufacturing products and highly demanded capital goods.

Muddling through

Germany’s resilience and dominant size within the EU may explain its ‘muddling through’ approach towards the Eurozone crisis – doing enough to prevent the unravelling of the Eurozone while resisting policies that may mitigate the depth of the crisis if they involve short-run costs to Germany.

A manifestation of this approach is the revealed asymmetric bias of the ECB’s inflation targeting. The short history of the ECB reveals a strong deflationary bias, which probably reflects the well-known German aversion to moderate inflation.8 So far, we have not seen the willingness of the ECB to follow symmetric inflation targeting. Observers have noted that the ECB’s revealed inflation targeting is closer to targeting Germany’s inflation rather than targeting inflation of the entire Eurozone. While this may not be a surprise considering the bargaining clout of Germany, the resultant low Eurozone inflation – approaching 0.5% as the time of writing – puts further drag on the adjustment of the GIIPS countries. The net outcome is the continuation of accelerated debt deflation, which pushes the Eurozone toward the prospect of a Japanese-style lost decade (see Moghadam et al. 2014).9

Another manifestation of Germany’s ‘muddling through’ approach is the prevalent view of German observers that its persistent current-account surplus is a reflection of the country’s efficiency and is irrelevant to the adjustment challenges facing the global economy, the Eurozone, and the GIIPS countries.10 Ironically, Germany’s attitude toward the Eurozone resembles the attitude of the US toward the Bretton Woods system in the 1960s – benign neglect of the growing tensions, which led to the ultimate demise of the Bretton Woods system (see Zimmermann 2002).11 Chances are that unravelling the Eurozone would be much more costly than the end of the Bretton Woods regime (see Eichengreen 2013).

Towards a more resilient and successful union?

Approaching the fifth year of the Eurozone crisis, one detects green shoots that, with proper stewardship, may lead to the emergence of a more resilient and successful union. Recent output projections suggest that the worst may be over for GIIPS countries, and recovery may be around the corner. Their primary fiscal deficits have been drastically trimmed and are moving toward surpluses. GIIPS countries are also gaining access to borrowing at declining sovereign spreads. These developments may be the bonus of the ‘positive contagion’ triggered by Draghi’s policy stance. The challenges facing the ECB and Germany is to do what it takes to prevent a reversal of these gains. The tentative recovery of GIIPS may be threatened if and when global interest rates rise, or when the risk tolerance towards GIIPS debt deteriorates. The chance of pushing these countries’ future to the wrong side of the debt Laffer curve would be mitigated by a greater willingness for debt concessions tied to deeper structural reforms. The mixed messages from Germany regarding its lacklustre support of Draghi’s policies – including the country’s constitutional court ‘thunderbolt’ ruling in February – are the elephant in the room, raising serious questions about the durability of any green shoots.

In the same vein, the Balkanisation of the banking system induced by the Eurozone crisis is also a double-edged sword. Rapid financial integration in the Eurozone prior to setting efficient and prudent supervision and banking union helped contribute to over-borrowing by GIIPS. The challenge facing the Eurozone financial system remains that of finding a healthy balance between banking integration and prudent regulations. This challenge remains a work in progress in both the US and the Eurozone, and time will tell if GIIPS countries’ greater access to renewed borrowing will backfire. An underappreciated development has been the growing mobility of labour in the Eurozone and in the rest of the EU.13 Although this mobility is mostly confined to younger workers and immigrants, it facilitates easier adjustment and increases the flexibility of labour markets. Greater mobility of labour and lower mobility of under-regulated capital may be the costly ‘second best’ adjustment until the arrival of more mature institutions in the Eurozone.

The ‘muddling through’ process may prove to be a stepping stone toward a more perfect euro union. The challenges facing the Eurozone are not unforeseen or unprecedented. The history of other unions provides examples where crises, with the proper leadership, created new institutions and upgraded existing ones in ways that increased their resilience.14

Author’s note: Insightful comments by Jerry Cohen, Barry Eichengreen, Andrew Rose, Paul Wachtel, and the 20th Dubrovnik Economic Conference participants are gratefully acknowledged.


Aizenman, J (2004), “Financial Opening: Evidence and Policy Options”, in R Baldwin and A Winters (eds.), Challenges to Globalization, University of Chicago Press: 473–498. 

Aizenman, J, B Pinto, and A Radziwill (2007), “Sources for Financing Domestic Capital – Is Foreign Saving a Viable Option for Developing Countries?”, Journal of International Money and Finance, 26: 682–702.

Aizenman, J (2012), “The Euro and the global crises: finding the balance between short term stabilization and forward looking reforms”,, 5 June.

Aizenman, J (2014), “The Eurocrisis: Muddling Through, or On the Way to a More Perfect Euro Union?”, NBER Working Paper 20242.

Cohen, Benjamin (1994), “Beyond EMU: The problem of sustainability”, in B Eichengreen and J Frieden (eds.), The Political Economy of European Monetary Unification, Boulder, CO: Westview.

Eichengreen, Barry (2013), “Mother of all sudden stops”,, 14 September. 

Fratzscher, Marcel (2013), “Investment, not the surplus, is Germany’s big problem”, Financial Times, 18 November.

Issing, Otmar (2006) “The euro – a currency without a state”, Helsinki, 24 March. 

Gourinchas, Pierre-Olivier and Olivier Jeanne (2006), “The Elusive Gains from International Financial Integration”, Review of Economic Studies, 73: 715–741.

Jauer, Julia, Thomas Liebig, John P Martin, and Patrick Puhani (2014), “Migration as an adjustment mechanism in the crisis? A comparison of Europe and the United States”, OECD Social, Employment and Migration Working Paper 155.

Moghadam, Reza, Ranjit Teja, and Pelin Berkmen (2014), “Euro Area – ‘Deflation’ Versus ‘Lowflation’”, iMFdirect, 4 March. 

Prasad, Eswar S, Raghuram G Rajan, and Arvind Subramanian (2007), “Foreign Capital and Economic Growth”, Brookings Papers on Economic Activity, 1: 153–209.

Rajan, R (2005), “Has Financial Development Made the World Riskier?”, Proceedings of the Jackson Hole Economic Policy Symposium, Federal Reserve Bank of Kansas City, August: 313–369.

Schäuble, W (2013), “Ignore the doomsayers: Europe is being fixed”, Financial Times, 16 September.

Zimmermann, Hubert (2002), “The fall of Bretton Woods and the emergence of the Werner Plan”, in From the Werner Plan to the EMU: in search of a political economy for Europe, Brussels: PIE Lang: 49–72.


1 “After more than seven years, the euro is firmly established as the currency of over 300 million people. Its internal stability is evidenced by the fact that inflation has been steadily low from the very start, despite a sequence of negative price shocks (in particular a continuous surge in oil prices). As an international currency, the euro is second only to the US dollar.”

“The EU has always been, and will remain, a unique undertaking for which there are no models that can easily be adopted. It is important to allow an evolutionary process, which is open to further steps of integration, yet safeguards what is already in place and working well, and which assigns competencies to nation states or even regions as appropriate. In fact, we have been in the midst of such a process for quite some time, and Monetary Union is and will remain one of its major success stories.”

(The opening and the closing of a speech by Otmar Issing, Member of the Executive Board of the ECB, in Helsinki on 24 March 2006.)

2 The IMF’s World Economic Outlook (October 2008: 228) noted “…emerging Europe’s ability to borrow foreign capital for long periods suggests that the standard growth model, with capital flowing downhill, remains relevant.” “In emerging Europe, the large current account deficits are related to a rapid liberalization of domestic financial markets and open capital accounts, which attracted large capital inflows and prompted a rapid rise of foreign bank ownership. The process of integration into the EU also enhanced foreign capital inflows by improving prospects for economic and policy stability.”

3 Gourinchas and Jeanne (2006) found that the welfare gains in switching from financial autarky to full capital mobility equal a paltry 1% increase in domestic consumption for the typical emerging market. Aizenman et al. (2007) and Prasad et al. (2007) noted that fast-growing developing countries have tended to self-finance their investment, and run current-account surpluses.

4 See Aizenman (2013) for further discussion and references dealing with the evolutionary approach of forming currency unions and new institutions.

5 The second stability condition is the presence “of a broader constellation of related ties and commitments sufficient to make the loss of monetary autonomy, whatever the magnitude of prospective adjustment costs, seem basically acceptable to each partner.”

6 Ironically, there are curious parallels between the global role of the US since the end of the Bretton Woods system and the role of Germany in the Eurozone. The presumption in the 1970s was that the demise of the Bretton Woods system would propagate a symmetric global-financial architecture, where major currencies would freely float against each other. Within two decades, it became clear that in the post-Bretton Woods system, the US had kept its hegemony. The US dollar has retained its position as the leading global currency, with the country enjoying the exorbitant privilege of running growing current-account deficits supported by an increasingly vibrant demand for US government bonds by the foreign central banks, as well as by the private sector in foreign countries (as a ‘safe haven’ asset). The global financial crisis, propagated globally from the US, induced a reluctant US Treasury and Federal Reserve Board to adopt unprecedented steps aiming at stabilising the global economy. In the same vein, the presumption was that forming the euro as ‘a currency without a state’ would provide a more symmetric structure to Europe and contain the fear of a German hegemony. This supposition seemed to work only in ‘good times’ – the first decade of the euro.

7 Chances are that the elusive “Great Moderation” did not help by masking the growing tail risks in the OECD countries (Rajan (2005)). The countries joining the Eurozone experienced two decades of growing optimism associated with their deepening financial integration and convergence to low inflation before the Eurozone version of the “capital flight” crisis hit.

8 A hint of this bias is provided in Issing’s (2006) opening statement cited above. A symmetric inflation targeting would also require an aggressive expansionary-monetary policy in the presence of a sequence of deflationary prices shocks, such as a sequence of lower prices of commodities, and other deflationary developments that impact the Eurozone’s consumer price index (CPI).

9 There are several key differences making a lost decade much more destabilising in the Eurozone than in Japan. Unlike the Eurozone, Japan is a mature currency and fiscal union of its 47 prefectures, a country with a large net foreign asset position, and overall homogenous population and economic structure. In contrast, low employment and growth in the Eurozone would increase the strength of the ‘anti-euro’ camp, leading to deeper social and political instability and threatening the survival of the Eurozone.

10 The debate about the merits of current-account imbalances is as old as the debate about the merits of financial integration. Supporters of current-account surpluses tend to focus on competitiveness as the key driver of surpluses, viewing it as a virtue (see Schäuble 2013). Opponents of current-account surpluses focus on the truism that current-account surplus reflects the excess of saving over investment (see Martin Wolf’s column in the 16 September edition of the Financial Times). On balance, this debate is less relevant at times of strong global growth, but at times of global deflationary stance, the global adding-up property – stating that the sum of global current accounts is zero – matters. It implies that current accounts of large countries matter in the global distribution of employment and economic activities. The sheer size of Germany suggests that its current-account surpluses have a non-trivial effect on the Eurozone and the global economy (see Fratzscher’s 18 November 2013 column in the Financial Times). At times of global deflationary pressure, global employment is not a zero-sum game – higher investment and lower saving in surplus countries would help in mitigating global protectionist threats and underemployment pressures.

11 “…the new [Nixon’s] government took no initiative to do anything about the monetary turmoil as long as it did not see its domestic priorities endangered by the “market”. Frist, it tried to get domestic inflation under control by tightening macroeconomic policies and cutting government expenditure. When this policy failed and appeared to scare away voters, the government undertook a series of expansionary steps which struck the fatal blow to the Bretton Woods system. … As a result of the policy of “benign neglect”, however, the US deficits rose out of all proportion. When the dollar-holders desperately tried to cash in their reserves, Nixon acted in August 1971, after years of precipitously increasing speculative crises, closed the gold window, imposing a ten percent surtax on all imports.” Zimmermann (2002: 66).

12 The banking system of the US was ‘Balkanised’ during the three decades after WWII. While this system came with its costs, the US grew at a healthy rate during that period. The deregulation of the US banking system in the 1990s came with its short-term benefits, and the longer-run costs manifested during the 2008–2009 crisis. Chances are that the growth challenges of countries are less the balkanisation of their banking and financial systems, and more their structural distortions.

13 Jauer et al. (2014) reported “there is tentative evidence that the migration response to the crisis has been considerable in Europe, in contrast to the United States where the crisis and subsequent sluggish recovery were not accompanied by greater interregional labour mobility in reaction to labour market shocks. Our estimates suggest that, if all measured population changes in Europe were due to migration for employment purposes – i.e. an upper-bound estimate – up to about a quarter of the asymmetric labour market shock would be absorbed by migration within a year. However, in the Eurozone the reaction mainly stems from migration of third-country nationals. Even within the group of Eurozone nationals, a significant part of the free mobility stems from immigrants from third countries who have taken on the nationality of their Eurozone host country.”

14 This is in line with European Commission President Romano Prodi statement in 1999, “I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”


Topics: Institutions and economics, International finance, Monetary policy
Tags: ECB, euro, eurozone, Eurozone crisis, Germany, GIIPS, inflation targeting, institutions

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER