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Luke Mariani
The EMU Debt Crisis
Even prior to the inception of the euro in 1999, the topic of a single currency for multiple
countries had been widely debated. However, motivated by a prospect of regional stability, and assured
by strength of a German economy, 19 countries in Europe have since joined a monetary union under a
common currency. Since the integration of the euro, many different, significant fiscal event have
occurred, and have tested the strength and durability of not only the euro itself, but also the individual
countries that comprise the Eurozone. Recently, the current economic state in some Eurozone countries
has raised speculation about the stability of the region as a whole. It has also stimulated hindsight
reasoning about whether some of the weaker countries should have been admitted in the first place.
With bailouts for Spain, Portugal, Ireland, Cyprus, and three for Greece, the power and stability
promised by the euro has come into question. This essay will analyze how and why the EMU debt
crisis occurred.
It is important to note that the European Monetary Union (henceforth referred to as the EMU) is
solely a monetary union; not a fiscal policy union. Originally, the goal of the euro was to promote
stability throughout the Eurozone. This stability heavily relied on the large economies of Germany,
France, and Italy. When the single currency was formed, a new policy was imposed on the member
countries, and they no longer had control of their respective monetary policies, but maintained control
of their fiscal systems.
To understand the current state of the euro, we must first analyze the past. In the time leading to
the 2008 financial crisis, countries such as Greece, Spain, and Ireland were capitalizing on low interest

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rates to finance investment, and as the global economy improved, the weaknesses in the euro remained
hidden. While this happened, government bonds in the Eurozone underestimated the risks associated
with poorly maintained fiscal policy in the region. “In fact, EU accession generally fast tracked the
convergence in sovereign bond yields around a narrow range. A common monetary policy and zero
exchange rate risk may have been the driving forces behind this remarkable convergence in the euro
area bond yields between about 2002 and July, 2007. ” (Antu Murshid) This convergence can also be
attributed to strong belief in the stability of the currency. Also, investors were looking at the euro
region as a whole, rather than on a country to country basis. With easily accessible credit, the housing
markets in many Eurozone countries boomed. However, when the American housing bubble burst, the
effects were felt globally. “When a slowdown in the US economy caused over-extended American
homeowners to default on their mortgages, banks all over the world with investments linked to those
mortgages started losing money. America’s fourth largest investment bank, Lehman brothers, collapsed
under the weight of its bad investments, scaring other banks and investors with which it did business.
The fear that more banks could fail caused investors and banks to take extreme precautions. Banks
stopped lending to each other, pushing those reliant on such loans close to the edge.” (European
Commision 2014) European banks that had invested heavily in a growing housing market experienced
harsh negative effects. As the banks began to fail, European governments intervened to prevent
collapse. In Ireland, the high costs of the bailouts brought the country to the brink of failure. This is
when other EMU countries stepped in to lend a hand. Prior to the European recession in 2009, “markets
priced neither macro-fundamentals nor the very low, at the time, international risk factor. This finding
is consistent with the ‘convergence-trading’ hypothesis, according to which markets were discounting
only the optimistic scenario of full real convergence of all EMU economies to the German one.”
(European Commision 2011). Almost like a flip of a switch, this all changed. In the wake of the
banking sector collapse, investors began looking at the fiscal positions of individual countries instead
of the overall position of the region.

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When countries entered the euro they benefited from low yield rates due to confidence in the
stability of the region, and the backing of a strong German economy; some took advantage of this new
access to financing. Greece specifically was singled out as a problem, with previous governments
building up “debts nearly twice the size of the economy” (European Commission 2014). Now, with the
weak fiscal positions of certain countries coming to light, and with market failures seeming
increasingly likely, investors demanded higher risk premiums on government securities from countries
like Greece. “Yields diverged substantially and cross-market linkages also weakened, as investors
became more discerning about idiosyncratic country risks.” (Antu Murshid) When bond yield rates
increased, it became more difficult for the weaker countries to finance investment. This in turn
increased perceptions of default, which pushed risk premiums higher. What occurred was a mass
withdraw of funds from risk-heavy countries. This led to extreme imbalances between member
country's economic standings in their current accounts, public finances, and competitiveness. Currently,
measures are being taken to mend the short-term debt problems, correct long-term underlying
weaknesses, and return the EMU to a position of balanced, stable growth.
Questions have been raised about whether the EMU debt crisis could have been averted with
some foresight prior to the inception of the euro. The EMU was seen as the next step in economic
integration for the European Union, since it was founded in 1957. The main backbone of stability was
the Maastricht criteria, which still has to be met before a country can enter the third stage of the EMU,
and adopt the euro as its currency. The main 2 criteria that are of concern are that the debt-to-GDP ratio
of the country must not exceed 60%, and that government budget deficits must not exceed 3%.
However, there were no binding sanctions to these criteria, therefore they did not sufficiently deter
countries from running large deficits, or covering up those deficits by use of complex currency and
derivative structures. In fact, in 2009 it was revealed that Greece's debt-to-GDP was 129.7%, and it

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had a budget deficit of 13.6% (Eurostat 2016). Greece was not alone, many other EMU countries
maintained deficits and debt-to-GDP ratios that exceeded the Maastricht criteria. The euro region
collected together to form the European Stability Mechanism (ESM), a permanent support fund, which
allowed Eurozone countries emergency access to funds, with a maximum lending allotment of 500
billion euros. The EMU also decided to make 150 billion euros available for bilateral lending to the
IMF. Since the IMF demands strict austerity measures to be taken in order to secure a loan, this would
help to reduce the problem of disobeying criteria. Additionally, the Stability and Growth Pact, an
agreement to promote regional stability, now requires countries with debt-to-GDP ratios exceeding
60% to reduce their debt-to-GDP ratio by one twentieth of a percent per year. If strict measures had
been in place prior to the inception of the euro, and had the fiscal policies of the member countries been
under heavier scrutiny, then some of the problems that the EMU faces today may have been averted.
It is easy to speak in hindsight; to say that exclusion from the union would have been beneficial
to all remaining member countries, and recently there have been calls for weak countries like Greece to
exit the euro. While looking backwards is easy, having foresight proves slightly more difficult. It is
effectively impossible for a country to exit the euro once it has joined. The economic cost of a highly
devalued domestic currency would put strain on an already strained economy. Also, the political cost of
an exit would deface any positive standing that the exiting country holds in international forums. The
country would no longer be as welcome at international meetings, nor would its opinions be taken
seriously. The largest cost, however, is the procedural one. “Reintroducing the national currency would
require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages,
taxes, and most everything else – to be redenominated in the domestic currency. The legislature could
pass a law requiring banks, firms, households and governments to redenominate their contracts in this
manner.” (Barry Eichengreen 2007) This would take a great deal of time and planning, and in that time
the country would see a run on banks as many households and firms move their money out of the

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country to avoid devaluation.
In summary, a collapse in the American housing market produced a negative shock overseas,
and when European governments began bailing out their banks, it became clear that the fiscal position
of many countries in the EMU were not in a good position. Investors began measuring risk on a
country to country basis causing government bond yields to diverge significantly. This exacerbated the
problem, making it increasingly difficult for failing countries to meet their obligations, which made
investors again demand higher risk premiums, continuing the cycle. All of these event occurred due to
lenient sanctions from disobeying the Maastricht criteria, and a lack of fiscal policy scrutiny as a whole
from the EMU. If the EMU had stricter criteria for admittance, or had harsher sanctions for
disobedience, some of these problems may have been avoided. Unfortunately, once a country joins the
euro, it is near impossible to exit without causing a crisis worse than the current EMU debt crisis.
Europe will have to live with its shortsightedness, and try to implement policy reform to correct what
has already gone wrong in order to stabilize a currency that holds them together.

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Buti, Marco, and Nicolas Carnot. "The EMU Debt Crisis: Early Lessons and Reforms*." JCMS: Journal of
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Web. 09 Dec. 2015.
"VOX CEPR's Policy Portal."Was the Euro a Mistake? N.p., n.d. Web. 09 Dec. 2015.
"Eurostat - Tables, Graphs and Maps Interface (TGM) Table." Eurostat - Tables, Graphs and Maps Interface
(TGM) Table. N.p., n.d. Web. 09 Dec. 2015.