This document discusses the structural defects and ineffective policies that have contributed to the Euro crisis. It argues that the Eurozone fails to meet many of the criteria for an optimal currency union, specifically lacking high labor mobility, risk sharing mechanisms across countries, and synchronized business cycles. While capital mobility is strong within the Eurozone, austerity policies have failed to curb high debts and struggling countries lack a unified monetary policy response. The Eurozone faces an existential crisis of whether it can reform to become a more optimal currency zone or if it can survive in its current form.

1.
The
Euro
Crisis:
Structural
Defects
and
Ineffective
Policy
By:
Alec
Mitchell
Econ
442,
Professor
Menzie
Chinn
5/11/2015

2. Mitchell
1
Introduction
While
the
collapse
of
Lehman
Brothers
in
September
of
2008
was
the
actual
explosion
in
the
coal
mine
for
the
United
States,
the
Eurozone
failed
to
view
it
as
they
should
have:
a
canary
for
the
longstanding
gas
leak
that
is
the
imperfect
Euro
currency
union.
Just
over
a
year
later,
Ireland
and
Greece
saw
their
interest
rates
quickly
and
suddenly
rise
past
their
Euro
counterparts
for
the
first
time
since
entering
the
union1
(Table
1).
The
cause
of
the
rise
was
mixed
across
the
board,
reflecting
the
diverse
nature
of
the
Eurozone.
In
Ireland,
the
housing
bubble
crash
looked
eerily
similar
to
the
United
States,
but
was
magnified
by
the
fact
that
Irish
banks
were
larger
in
proportion
to
Irish
GDP,
making
bailouts
more
costly
for
the
small
nation.
For
Greece,
longstanding
high
deficits
and
revelations
as
to
their
actual
levels
of
debt
led
to
uncertainty
in
the
markets.
Along
with
the
rest
of
the
Eurozone,
both
were
hit
by
a
decrease
in
US
imports
from
Europe
and
a
devaluation
of
the
dollar
relative
to
the
Euro
heading
into
2010
(Table
2).
The
Eurozone’s
Problem
In
an
ideal
currency
union,
there
is
high
labor
and
capital
mobility,
risk
smoothing,
and
symmetric
business
cycles
among
regions.
For
the
Eurozone,
however,
only
one
of
these
seems
to
be
true
in
capital
mobility.
While
the
zone
rode
out
the
beginning
of
the
US
crisis,
cracks
began
to
show
within
a
year.
Austerity
policies
put
in
place
to
solve
high
debts
have
failed
to
stem
the
crisis,
and
a
lack
of
unified
monetary
policy
has
crippled
struggling
countries.
The
problem
now
facing
the
Eurozone
is
one
of
existential
proportions:
can
it
become
a
more
optimal
currency
zone?
If
not,
should
it,
and
can
it,
survive?

3. Mitchell
2
Optimality
of
the
Zone
The
Eurozone’s
performance
on
the
first
condition
of
optimality,
labor
mobility,
pales
in
comparison
to
the
United
States.
Blanchard
and
Katz’s
prescient
1992
paper
described
the
difficulty
that
the
Eurozone
would
have
in
terms
of
labor
mobility;
they
showed
that
individual
US
states
tend
to
recover
from
asymmetric
shocks
through
moderate
to
high
labor
mobility.2
In
fact,
a
2014
European
Commission
report
estimated
that
cross-­‐country
mobility
in
the
EU
was
.2
percent,
less
than
one-­‐tenth
of
the
2.7
percent
state-­‐to-­‐state
mobility
in
the
US.3
This
does
not
bode
well
for
the
Eurozone
considering
that
the
pressures
faced
by
individual
depressed
countries
are
due,
in
large
part,
to
external
demand
imbalances.
A
2015
working
paper
by
Emmanuel
Farhi
and
Ivan
Werning
shows
that
mobility
out
of
depressed
regions
has
a
significantly
positive
effect
on
those
who
decide
to
stay,
but
only
when
the
source
of
demand
imbalances
is
external
(such
as
the
current
Euro
Crisis).4
In
sum,
the
unique
structure
of
the
Eurozone
puts
it
at
a
disadvantage
for
the
first
pillar
of
optimality,
a
condition
that
may
need
to
change
if
it
is
to
survive.
The
strongest
area
for
the
Eurozone
is
capital
mobility,
with
both
historical
and
current
trade
agreements
providing
a
strong
base.
The
1957
Treaty
of
Rome,
a
precursor
to
the
eventual
Treaty
of
Maastricht,
created
the
European
Economic
Community,
which
provided
for
common
goods
markets
and
customs
rates.
The
treaty
was
a
foundation
on
which
the
future
Eurozone
established
strong
capital
mobility.
Authority
over
the
customs
union
was
transferred
to
the
European
Union
after
its
inception,
and
was
expanded
to
include
all
member
states.
Additionally,
the
introduction
of
a
single
currency
has
made
transfer
of
capital
easier,
to
the
tune
of
an
approximate
10
percent
increase.5

4. Mitchell
3
Perhaps
the
Eurozone’s
trickiest
yet
most
necessary
problem
to
change,
risk
smoothing
across
countries
is
notably
absent
in
the
Eurozone.
Ironically,
the
Eurozone
resembles
the
short-­‐lived
Articles
of
Confederation
in
the
United
States,
with
the
central
authority
unable
to
implement
many
fiscal
or
monetary
policies
without
support
from
member
states.
Unlike
the
current
United
States
system,
whereby
the
federal
government
can
shift
tax
burdens
and
benefits
to
states
hit
by
asymmetric
shocks,
the
Eurozone
is
not
set
up
to
complete
such
actions.
The
supremacy
of
individual
members
over
the
European
Parliament
and
Central
Bank
puts
a
major
damper
on
the
ability
to
shift
benefits
around
the
Union.
Individual
member
states
would
need
to
use
their
own
tax
receipts
to
support
failing
countries,
something
politically
difficult
for
national
legislatures.
Indeed,
the
European
Fiscal
Compact
forces
members
to
keep
their
deficits
under
3
percent
or
face
fines,
and
Germany
has
so
far
stood
strong
in
refusing
the
most
recent
bailout
offers
from
Greece.6
On
the
monetary
policy
front,
quantitative
easing
has
long
been
off
the
table
due
to
both
structural
EU
requirements
and
German
opposition.7
Simply
put,
current
fiscal
and
monetary
policies
do
not
align
with
necessary
structures
required
for
an
optimal
currency
union.
The
last
problem
facing
the
Eurozone
is
the
asymmetric
business
cycles
facing
member
states.
A
2008
research
paper
estimated
that
there
were
two
groups
of
countries:
a
core
and
a
periphery.
The
core
consisted
of
Germany,
France,
The
Netherlands,
and
Finland
(among
others),
while
the
periphery
was
rounded
out
by
Greece,
Ireland,
Portugal,
and
Spain.1
In
addition
to
finding
that
both
groups
are
indeed
out
of
cycle,
the
researchers
also
found
that
the
Euro
has
done
little
to
bring
them
into
alignment.8
As
such,
it
is
difficult
1
The
last
GIIPS
country,
Italy,
was
the
only
one
included
within
the
core
group

5. Mitchell
4
for
a
central
bank
to
utilize
many
available
monetary
policies
in
a
way
that
can
help
buoy
the
struggling
periphery
countries,
while
not
also
harming
the
stable
core
countries.
How
the
Crisis
Has
Played
Out
Eurozone
Policy
The
Treaty
of
Lisbon
and
previous
pacts
in
the
EU
impose
significant
restrictions
on
Euro-­‐wide
policy
and
place
heavy
burdens
on
member
states
to
keep
their
financial
conditions
within
certain
bounds.
Article
123
imposes
a
prohibition
on
the
“direct”
purchase
by
the
ECB
of
“(Union
Institution)
debt
instruments,”
and
many
have
interpreted
this
to
preclude
any
monetary
financing
whatsoever.
9
Article
124
prohibits
privileged
access
to
financial
institutions
for
any
union
institution.10
In
addition,
article
125
imposes
severe
restrictions
on
the
ability
of
the
EU
to
“bail
out”
any
government
within
the
EU.11
The
European
Fiscal
Compact,
signed
in
2012,
places
tighter
controls
on
the
longstanding
policy
that
member
countries
must
have
less
than
3
percent
deficit
to
GDP
and
60
percent
debt
to
GDP
ratios.12
Finally,
all
monetary
policy
is
complicated
by
the
fact
that
the
ECB’s
primary
job
is
limited
to
keeping
inflation
close
to
2
percent.13
These
policies,
while
not
inherently
meant
to
impede
recovery,
clash
with
what
many
economists
consider
the
best
set
of
policies
in
a
recession.
The
most
confusing
policy
stance
is
the
EU’s
resistance
to
quantitative
easing
in
the
sovereign
bond
and
securities
markets.
Most
advanced
economies
rely
on
countercyclical
monetary
policy
to
smooth
the
business
cycle,
encouraging
growth
in
troughs
and
putting
on
the
brakes
during
peaks.14
Such
action
in
recessions
can
lower
interest
rates
by
driving
up
the
demand
in
sovereign
bond
markets,
which
have
seen
skyrocketing
interest
rates
for
Ireland
and
Greece.
However,
Article
123
and
the
ECB’s
own
instructions
effectively
limit
their
ability
to
enact

6. Mitchell
5
any
such
policy,
even
as
the
crisis
has
leapt
to
historic
proportions
across
the
globe
and
EU.
Finally,
only
two
months
ago,
years
after
the
crisis
began,
the
ECB
began
a
€1.1
trillion
secondary
market
bond-­‐buying
program,
now
under
intense
political
and
legal
controversy.15
So
why
was
policy
not
changed?
In
short,
political
considerations
trumped
economic
theory.
Germany,
the
economic
bedrock
of
the
Eurozone,
has
flat
out
refused
to
accept
such
relief
to
debt
stricken
countries.
Both
of
their
ECB
board
members
have
openly
opposed
such
actions,
and
Chancellor
Angela
Merkel
has
expressed
her
worry
that
such
actions
will
allow
distressed
countries
to
delay
or
even
fail
to
enact
deficit-­‐cutting
reforms.16
These
debt
reforms,
embedded
within
the
European
Fiscal
Compact,
go
against
a
much
more
controversial
area
of
economic
theory.
In
order
for
countries
such
as
Ireland
and
Greece
to
hit
the
3
percent
deficit
and
60
percent
debt
marks,
higher
taxes
and/or
extreme
austerity
measures
have
to
be
implemented.
Some
decision
makers
used
a
widely
cited
research
paper
by
Reinhart
and
Rogoff
as
empirical
evidence
that
high
debt
leads
to
slower
growth,
therefore
vindicating
the
Eurozone’s
strict
policies.17
However,
many
economists
criticized
the
paper,
and
the
authors
were
forced
to
clarify
that
the
two
were
found
to
be
“associated,”
not
necessary
cause
and
effect.18
Yet,
other
research
has
found
that
debt
can
actually
have
a
positive
effect
on
GDP
growth,
up
to
certain
points.19
Even
further,
some
research
has
found
no
threshold
at
which
GDP
growth
is
hampered
by
additional
debt.20
So
what
is
the
correct
policy
choice
here?
The
general
consensus
in
the
economic
realm
is
that
higher
deficits
and
debt
in
the
short
run
can
certainly
have
positive
effects
on
growth,
much
in
line
with
the
Keynesian
aggregate
demand
models.
The
most
uncertainty
occurs,
however,
on
whether
there
is
a
certain
level
of
debt
that
starts
to

7. Mitchell
6
impede
growth
in
the
long
run.
Therefore,
it
seems
likely
that
the
EU
policy
here
is
likewise
counter
to
what
should
be
pursued
in
recessed
economies,
but
the
evidence
is
not
as
firmly
grounded
as
is
countercyclical
monetary
policy.
The
last
controversial
Eurozone
recessionary
policy
is
the
prohibition
on
most
bail-­‐
outs.
Unlike
countercyclical
and
austerity
policies,
the
evidence
on
bail-­‐outs
is
decidedly
mixed,
with
economists
landing
on
both
ends
of
the
scale.
On
one
hand,
when
assessing
the
effects
of
the
US
bailout,
a
University
of
Chicago
forum
polled
49
leading
economists,
who
on
average
agreed
that
its
benefits
outweighed
the
costs,
that
unemployment
was
lower
as
a
result,
and
that
businesses
were
not
be
incentivized
to
harm
the
economy
further.21
Additionally,
empirical
research
has
shown
that
not
only
are
bailouts
necessary
to
prevent
a
banking
crisis
which
would
wreak
havoc
on
an
economy,
but
even
that
Chancellor
Merkel’s
strong
resistance
to
such
policies
led
to
higher
bailout
costs
for
distressed
countries.22
On
the
other
hand,
research
of
the
US
bailout
has
found
that
banks
did
end
up
having
riskier
portfolios
after
they
were
bailed
out,
evidence
of
a
moral
hazard.23
What
is
seen
overall
is
that
economic
theory
tends
to
agree
that
a
bailout
of
some
undercapitalized
financial
institutions
is
necessary
to
avoid
further
economic
shock,
but
some
economists
show
that
there
is
proof
that
those
institutions
continue
the
same
risky
behavior.
Here,
Chancellor
Merkel’s
concerns
about
moral
hazard
find
stronger
ground.
Bailouts
seem
to
be
beneficial
to
an
economy
when
they
include
strong
regulations
to
prevent
mistakes
from
happening
again.
However,
Germany’s
insistence
for
bailouts
paired
with
strict
austerity
measures
muddles
recovery.
So,
how
do
these
policies
fit
within
specific
Eurozone
countries?
Below,
the
examples
of
Ireland
and
Greece
are
considered.
Irish
banks,
second
largest
in
the
world
in

8. Mitchell
7
terms
of
GDP,
were
hit
hard
by
the
housing
bubble
and
their
economy
was
the
first
to
tumble.
Ireland
accepted
a
contentious
bailout
with
the
strict
austerity
that
Germany
wanted,
and
their
economy
has
recovered
in
part.
Greece,
bogged
down
by
a
drop
in
exports,
bank
bailouts,
and
high
interest
rates,
was
forced
to
implement
deep
austerity
in
accordance
with
bailout
partners.
Their
economy,
however,
has
turned
to
shambles.
Impact
on
Ireland
Ireland
was
hit
hardest
by
the
mortgage
and
financial
crisis.
Irish
banks,
with
increased
availability
of
capital
from
short
term
lending,
increased
their
balance
sheets
by
enormous
amounts.
In
2008,
Irish
banks
held
assets
worth
783
percent
of
GDP,
second
to
only
Luxembourg.24
The
vast
majority
of
these
assets
were
held
in
property,
while
at
the
same
time,
the
Irish
government
increased
spending
and
relied
more
heavily
on
property
taxes
to
make
up
government
revenue.
As
a
result,
in
2006
property
taxes
reached
of
peak
of
almost
20
percent
of
total
Irish
tax
revenue.25
This
reliance
on
property
by
both
the
Irish
financial
institutions
and
government
led
to
a
perfect
storm
as
the
housing
bubble
burst.
When
the
US
crisis
hit,
housing
prices
fell
and
borrowers
defaulted
on
payments.
The
short
term
borrowing
that
Irish
banks
had
so
heavily
relied
on
to
increase
their
balance
sheets
began
to
dry
up,
limiting
options
for
liquidity
as
the
banks
began
to
feel
the
squeeze.
As
banks
used
up
their
available
capital,
the
Irish
government
stepped
in
and
guaranteed
to
cover
the
liabilities
of
the
struggling
institutions.
However,
in
conjunction
with
sudden
structural
deficits
due
to
a
plunge
in
property
tax
revenue,
Irish
debt
soared
from
25
percent
of
GDP
in
2008
to
over
111
percent
by
2012.26
At
the
same
time,
Irish
yields
increased
from
4
percent
in
2008
to
almost
12
percent
by
the
middle
of
2011,
making
additional
borrowing
too
costly.27

9. Mitchell
8
The
one-­‐dimensional
scope
of
the
Irish
crisis
and
the
nature
of
their
exports
made
the
path
to
growth
difficult,
yet
simpler
than
Greece.
In
response
to
the
banking
and
emerging
government
debt
crisis,
Ireland
was
essentially
forced
into
a
European
Union/International
Monetary
Fund
bailout
by
the
ECB.28
The
recovery
has
since
been
slow
and
inconsistent.
Ireland’s
GDP
grew
3.2
percent
in
Q4
2012,
then
dropped
3.7
percent
the
next
quarter.
It
had
2
percent+
growth
in
Q3
2013
and
Q1
2014,
then
leveled
off
to
0.5
percent
in
the
last
two
quarters
of
2014.29
Unemployment
remains
at
10
percent,
wages
are
below
2007
levels,
and
consumer
spending
growth
lags
at
0.3
percent,
in
part
due
to
higher
taxes
implemented
to
comply
with
austerity
requirements.30,31,32
So,
while
the
bailout
certainly
aided
the
Irish
economy,
the
austerity
measures
possibly
hampered
recovery,
with
continued
low
consumer
spending,
low
growth
in
wages,
and
high
unemployment.
Impact
on
Greece
Unlike
Ireland,
which
was
impacted
mostly
by
the
banking
crash
and
housing
bubble,
Greece
was
hit
hardest
by
a
dramatic
drop
in
exports,
high
government
debt,
and
a
bookkeeping
scandal
that
scarred
the
government’s
credibility.
Greece’s
exports
are
mainly
low
value
raw
materials,
while
among
Greece’s
largest
trading
partners
are
Italy,
Turkey,
and
Cyprus,
all
hit
hardest
by
the
global
recession.33
Greece’s
exports
plummeted
21%
from
2008
to
2009,
only
recovering
to
their
2008
level
in
2014
(Table
3).34
Greece
also
faced
a
skyrocketing
level
of
government
debt:
from
2005-­‐2010,
their
debt
rose
from
100
percent
to
148
percent
of
GDP.35
With
a
disappearance
of
risk
and
interest
rates
tied
to
the
Euro
average,
Greece
was
able
to
borrow
large
amounts
of
money
at
what
turned
out
to
be
insanely
cheap
prices.
That
changed
when,
in
early
January,
2010,
the
European
Commission
released
a
shocking
report
that
accused
Greece
of
falsifying
records
to
cover

10. Mitchell
9
up
true
debt
levels.36
Within
one
year,
Greece’s
bond
yields
rose
from
6
percent
to
9.5
percent,
and
peaked
at
29.2
percent
in
early
2012
(Table
1).
With
skyrocketing
bond
yields,
Greece
was
hit
by
both
a
drop
in
tax
receipts
combined
with
the
inability
to
borrow
at
reasonable
prices.
Greece
was
given
two
bailouts
as
a
result
of
their
rising
debt
and
growth
crisis,
one
in
May
2010
and
another
in
July
2011.
Both
programs,
jointly
administered
by
the
EU,
ECB,
and
IMF2,
required
deep
austerity
cuts.
The
Greek
government
did
indeed
reduce
government
spending,
with
seven
successive
austerity
plans
from
2010-­‐2013,
cutting
public
workers’
pay,
overtime,
and
jobs,
while
raising
and
enforcing
existing
taxes
to
increase
receipts.
However,
unlike
Ireland’s
moderate
recovery,
Greece
plunged.
GDP
fell
every
quarter
from
2010-­‐2014,
110,000
businesses
declared
bankruptcy,
and
unemployment
rose
from
10
percent
to
27
percent.37,38
The
drop
in
public
sector
and
private
sector
employment
led
to
lower
tax
receipts,
and
massive
protests
led
to
even
lower
productivity
and
political
chaos.
With
an
inability
to
borrow
on
the
bond
market
and
pressures
from
the
bailout
troika,
Greece
continued
to
cut,
and
their
economy
continued
to
fall.
Only
recently,
in
January
2015,
did
Greece’s
anti-­‐austerity
party
SYRIZA
sweep
into
power,
promising
to
undo
the
austerity
measures
implemented
over
the
past
five
years.
The
Eurozone’s
policies
had
an
even
greater
effect
on
Greece
than
Ireland,
and
played
a
large
part
in
their
deep
recession.
First,
the
prohibition
on
countercyclical
monetary
policy
prevented
Greece
from
spending
money
on
a
stimulus
package
like
the
United
States.
Second,
the
ECB’s
decision
not
to
devalue
the
Euro
meant
that
the
drop
in
Greek
exports
had
no
cushion.
Third,
the
bailouts
and
their
strict
austerity
provisions
2
The
troika
partnership
was
formed
for
Ireland
and
Greece
in
part
because
of
the
severe
restrictions
placed
on
bailouts
by
Article
125

11. Mitchell
10
forced
Greece
to
cut
spending
by
massive
amounts,
in
the
hopes
that
international
investors
would
lower
bond
yields.
Quite
simply,
it
did
not
work.
The
drop
in
aggregate
demand
from
lower
government
spending
led
to
a
falling
GDP
and
higher
unemployment,
as
the
classical
Keynesian
model
predicts.
Greece
also
did
not
see
lower
sovereign
bond
interest
rates
until
mid-­‐2013,
so
borrowing
was
out
of
the
question.
While
SYRIZA’s
success
has
caused
a
rise
in
interest
rates
past
10
percent,
the
ECB’s
decision
to
finally
implement
a
quantitative
easing
program
should
help
dull
the
effects.
However,
many
economists
worry
that
the
plan
is
“too
little
too
late”,
and
that
the
Greek
economy
is
stuck
with
slow
growth
for
years
to
come.39
Conclusion
The
Eurozone
crisis’s
origins
can
be
blamed
partially
on
the
United
States,
but
the
slow
recovery
of
countries
like
Ireland
and
Greece
is
entirely
due
to
the
zone’s
optimality,
poor
government
management,
and
ineffective
EU
policies.
The
Euro
currency
union
has
low
labor
mobility,
poor
fiscal
policy,
and
asymmetric
business
cycles.
These
three
failures
have
led
to
the
current
crisis,
wherein
the
Eurozone
has
faced
its
biggest
test
yet.
At
the
same
time,
some
union
members
allowed
their
economic
situations
to
become
unstable.
Ireland’s
banks
ballooned
past
reasonable
sizes
and
Greece’s
debt
passed
100
percent
of
GDP.
When
the
crash
hit,
ECB
policies
with
regards
to
quantitative
easing,
deficit
reduction,
and
bailouts
slowed
their
recovery.
While
Ireland
has
gained
back
some
of
the
economic
indicators
it
lost
during
its
crisis,
severe
structural
problems
remain.
In
Greece,
the
policies
have
led
to
an
outright
depression.
Even
though
the
ECB’s
monetary
policy
may
finally
be
catching
up,
the
road
to
recovery
looks
long
and
tenuous.

12. Mitchell
11
1
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8
Giannone,
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Europa.eu.
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20
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14. Mitchell
13
Data
Source:
European
Central
Bank
Chart
Source:
Author
0
5
10
15
20
25
30
35
2015Mar
2014Dec
2014Sep
2014Jun
2014Mar
2013Dec
2013Sep
2013Jun
2013Mar
2012Dec
2012Sep
2012Jun
2012Mar
2011Dec
2011Sep
2011Jun
2011Mar
2010Dec
2010Sep
2010Jun
2010Mar
2009Dec
2009Sep
2009Jun
2009Mar
2008Dec
2008Sep
2008Jun
2008Mar
2007Dec
2007Sep
Interest
Rate
(%)
Month
Table
1
–
Interest
Rates
on
Eurozone
Country
Long-­‐Term
Bonds
Austria
Belgium
Germany
Spain
Finland
France
Greece
Ireland
Italy
Netherlands
Portugal
Lehman
Brothers
Collapse
Greece
Debt
Scandal

15. Mitchell
14
Data
source:
US
Census
Chart
source:
Author
15000
20000
25000
30000
35000
40000
Jan-­‐06
Mar-­‐06
May-­‐06
Jul-­‐06
Sep-­‐06
Nov-­‐06
Jan-­‐07
Mar-­‐07
May-­‐07
Jul-­‐07
Sep-­‐07
Nov-­‐07
Jan-­‐08
Mar-­‐08
May-­‐08
Jul-­‐08
Sep-­‐08
Nov-­‐08
Jan-­‐09
Mar-­‐09
May-­‐09
Jul-­‐09
Sep-­‐09
Nov-­‐09
Jan-­‐10
Mar-­‐10
May-­‐10
Jul-­‐10
Sep-­‐10
Nov-­‐10
Imports
($millions;
not
seasonally
adjusted)
Table
2
-­‐
Value
of
US
Imports
by
Month
Lehman
Brothers
Collapse

16. Mitchell
15
Data
Source:
Eurostat
Chart
Source:
Author
0
10000
20000
30000
40000
50000
60000
70000
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Value
of
Exports
(Millions
of
Euros)
Year
Table
3
-­‐
Value
of
Greek
Exports
by
Year
Export
Shock