Roots of the EZ crisis: Incomplete development and imperfect credibility of institutions

Giancarlo Corsetti

07 September 2015



Institutional deficiencies at the launch of the euro

At the birth of the euro, it was well understood that the fiscal, financial, and monetary institutions required for a sustainable currency union in Europe were not sufficiently developed. Actually, the euro was launched with a dangerously void institutional core:

  • The regulation, supervision, and resolution of financial intermediaries were extremely fragmented along national lines, with no common pool of resources to address crises.
  • The no-bail out clause was stated formally, without defining any of the institutions responsible for regulating cross-border fiscal insurance, ring fencing, and backstop, without which a restructuring is costly at national and systemic level.

The rule was not remotely credible. Without any common policy framework to manage national fiscal policy, nothing ensured the appropriate cyclical stance at Eurozone level.

  • Most importantly, there was no clear vision on which minimum standards of political and institutional cohesion among independent states would be required for the viability of the project.

Nonetheless, the consensus view was that the member states of the union would be able to reach agreement and cooperate on how to create the common currency institutions over time.

The history of European monetary institutions pre-dating the euro was brought to bear on the idea that institutional developments were bound to occur, most likely under the pressure of disruptive shocks and crises – a view typically attributed to Jean Monnet. Although negative shocks naturally create faulty lines and policy conflicts among policymakers, it was widely expected that, eventually, the forces in favour of integration and cooperation would prevail. The historical importance of tying together Europe would have provided sufficient motivation to overcome obstacles, smooth differences over policy, and elicit solidarity.

Perhaps it was just bad luck that exposed the danger and limits of relying on Monnet’s optimistic view. Nobody expected a crisis of the magnitude and scale of the Great Recession to occur, at least not so soon. But when the crisis struck, the reality was exposed. The monetary union was incomplete, hence vastly unprepared, with dreadful implications.

The outcome turned Monnet’s logic on its head. The process of building institutions and rules essential for a well-functioning currency union proved to be destabilising. A consensus on how to prevent and/or deal with macroeconomic and financial crises in the future had to be achieved together with an agreement on immediate emergency measures dealing with on-going shocks. As remarked by Marco Buti, building institutions after a shock means that their design will naturally create winners and losers ex post. Countries’ judgement and voting will be strongly influenced by immediate considerations, rather than by a fair assessment of the long-run consistency of the design. Unavoidable conflicts among national policymakers translated into uncertainty and delays in implementing desirable policy initiatives – especially apparent in comparison to the smooth and timely policy response to the crisis in the US.

It is well understood that a lack of policy credibility can expose an economy to a disruptive belief-driven crisis on the debt market. With the EZ crisis, the problem of credibility in the EZ became, so to speak, squared. It had both a domestic and a systemic dimension. In particular, the deep policy conflict on adjustment has systematically undermined the success of EZ interventions, and has often itself become a source of destabilising shocks.

  • Instability grew out of a disruptive deadlock between national governments forced to address and correct fundamental weaknesses in their national economies on their own, and the EZ-level policymaking, which could have created the conditions for successful implementation of national policies, but did too little too late (at best).

A comparison with the previous systemic crises hitting the institutions of European monetary cooperation provides insight on the problem.

  • During the 1992-93 crisis of the Exchange Rate Mechanism of the European Monetary System, countries had more instruments to absorb shocks and the crisis was relatively milder.

Exchange rate adjustment and moderate inflation at the national level arguably fostered and speeded up the correction of domestic imbalances. Yet, they also created trade-offs.

  • In the 1990s many countries had to pursue strongly recessionary policies to anchor inflation expectations and fence off speculative attacks on their currency; in those years, like today, domestic efforts alone could not and did not put an end to financial and currency turmoil in Europe.

Financial and macroeconomic stability was restored only after the Madrid summit in 1995, when, in part in recognition of the adjustment efforts at domestic level, European policymakers could rebuild political cohesion on the euro project.

In the current crisis, EZ member countries are precluded from relying on exchange rate adjustment and moderate inflation to speed up adjustment to shocks and imbalances. If anything, many countries face adverse trade-offs, e.g. between regaining competitiveness via a fall in prices and debt sustainability, which slow down the process. Here is the problem.

  • While increasing the social value of coordinated adjustment at union-level, slow domestic adjustment exacerbates the policy conflict and mistrust among national policymakers, undermining cohesion and cooperation.

The future of the Eurozone rests on breaking this deadlock, by developing an institutional framework that can credibly deliver stability at the EZ level.

Progress has already been made in regards to the banking union and a framework for containing and addressing sovereign crises, but it is difficult to see the exact shape that the institutional architecture of the EZ will take.

In what follows, I develop the argument exposed above by briefly reconstructing key phases of the crisis specific to the EZ. Given the space limitations, I will be selective in themes and omit some topics, like banking crises, which would require specific discussion. By no means is this omission meant to rule out their specific role in the crisis.

The policy conflict on adjustment let the ‘risk premia genie’ out of the bottle

It is worth recalling that the Eurozone did not fare badly in the first years of the Global Crisis. At a global level, the Great Recession starting in 2007-08 exposed the fragility of financial intermediaries and worsened the fiscal outlook of advanced countries. Participating in the European monetary union appeared to shelter countries from the early difficulties experienced by countries with a large financial sector relative to their tax base, such as the UK and Switzerland.

A striking reversal of fortune occurred in 2010. The ex-ante risky countries outside the EZ progressively managed to convince markets that they could weather the storm. They successfully put ‘the risk premia genie’ back in the bottle. Conversely, in the EZ, fault lines between EZ members with low and high debt (not necessarily higher than the ‘safe countries’ outside the EZ), translated into an open policy conflict on adjustment, which ultimately fed doubts about the stability of the Eurozone. With a vengeance, ‘the risk premia genie’ came out of the bottle, and EZ policymakers are still struggling to rein it in.

While different countries had different fundamental weaknesses, what ultimately became everybody’s main focus was the level of their debt.

  • In some cases, like Italy, the problem was the size of the outstanding public debt, resulting from many years of slow growth and loss of competitiveness.1
  • In other countries, like Spain and Ireland, abundant capital inflows had fed a housing boom and price inflation, associated with excessive credit expansion and, in the case of Spain, external imbalance.

The problem was the size of prospective contingent liabilities from banks’ losses, which translated into large prospective debt and deficit for the public sector.

  • In Greece, there was both a flow and a stock problem, with the emergence of a (long hidden) budget imbalance.

In all these cases the stock of (current and/or prospective/contingent) public liabilities was seen as too high relative to their capacity of fiscal and economic adjustment. As is well understood, a country can address its debt problem in three ways: Grow out of it; increase its surpluses, which is likely to entail economic and budget reforms to address the problem at its source; or restructure its stock of liabilities.2 With the growth option out of the picture (based on a fair assessment of the room for sustained economic expansions among industrial countries), the policy debate turned onto budget correction and debt restructuring.

Experience shows that in both the budget correction and debt restructuring cases, there are critical pre-conditions for their successful implementation. Key is some form of backstop to government and/or private debt, required to reduce the vulnerability of a country to belief-driven speculative attacks (see Corsetti and Dedola 2012). Eventually, the ECB was in a position to design the Outright Monetary Transactions (OMT) programme. But it took time, and in the meantime countries suffered unnecessary harm. Another precondition consists of an institutional framework setting clear and effective rules for managing solvency crises, of banks as well as of sovereigns, to reduce costs and risks of contagion effects.

In the absence of any credible institutional framework setting up rules and facilities to provide a backstop, to share losses and to enforce conditionality, European policymakers became deeply divided over policy strategies and the distribution of their costs, embracing opportunistic principles.

Due to this conflict, trust among policymakers quickly evaporated. Crisis countries were forced into austerity measures with counterproductive short-run effects and very little impact on risk premia, whose movements remained strongly correlated across borders. Countries that managed to emerge in a relatively stronger position had no intention to pursue expansionary policies and grant assistance to others, based on two arguments. First, they wanted to avoid any dilution of fiscal and macroeconomic discipline, as a strategy to prevent markets from charging their country a risk premium. Second, they share the belief that help and liquidity assistance to crisis countries would relax incentives to reform and embrace serious fiscal and macroeconomic correction.

The cost of the EZ crisis

The crisis of the Eurozone manifested itself in full force in 2011 when interest differentials between the crisis countries and Germany widened and became highly volatile. After the ECB announcement of the OMT programme, these differentials narrowed drastically. Although the market turmoil did not subside, the OMT represented a turning point in economic conditions.

Figure 1 shows the development of GDP in Germany, France, Spain, Italy and the UK between the first quarter of 2008 (=100) and the first quarter of 2015.

  • While contracting more, Italian GDP follows a very similar pattern to the GDP of France and the UK until the first half of 2011, as if the three were moved by a common factor.
  • After that date, when the sovereign debt crisis blows out in full force in the EZ, the UK and France kept improving; the Italian GD, instead, abruptly fell to about 9 percentage points below the level at the beginning of 2008, where it stabilised in 2013.

At the time of writing, the difference between the Italian and the UK GDP is as high as 12 percentage points. A similar story applies to Spain and other countries. Different from Italy, 2013 marked the beginning of a timid recovery in Spain.

While there is no doubt that weak Italian and Spanish fundamentals have played a key role in the above development, it is hard to maintain that the premia in financial markets were exclusively driven by domestic factors. Similar to the literature casting doubts on the stability of fixed exchange rates, seminal work in the literature on financial and debt crises have long made it clear that, with imperfect policy credibility, the market equilibrium is not necessarily unique (see Calvo 1988, recently revisited by Corsetti and Dedola 2012, and Cole and Kehoe 2000, among others; CEPR researchers have been key contributors in the field).3

The indeterminacy problems that come with multiple equilibria are exacerbated when policy rates are close to the zero lower bound and thus unresponsive to negative shocks (Mertens and Ravn 2010, Corsetti et al. 2013).

Figure 1. Real GDP for selected countries (Q1 2008 = 100).

Source: OECD.

The diabolic loop

The financial turmoil ignited as self-fulfilling prophecies had profound effects on economic behaviour and the state of the economy. Early on, CEPR researchers had warned about the diabolic loop set in motion by a sovereign risk premia crisis. Losses on banks’ holdings of sovereign debt transmit to the real economy via a credit crunch, which in turn feeds back onto lower taxes and thus higher public deficits, raising sovereign risk even further (see Brunnermeier et al. 2011; for an analysis of financial fragility see Ari 2015). Even more, sovereign risk can be expected to affect corporates’ risk more generally than just through the banks’ balance-sheet channel.

A high pass-through is detectable not only for small firms, which most likely rely on local banks. It is also detectable for large (multinational) corporates, which despite having their headquarters in a crisis country, have access to international financial intermediaries and markets. In joint work with Kuester, Meier and Mueller suggest that this feedback effect from sovereign risk to private borrowing costs is at the core of a sovereign risk channel of transmission (see Corsetti et al. 2013a,b).

Conservative estimates suggest that an increase in 100 basis points in the risk premia on sovereign debt implies an increase in financing costs for firms of about 40 to 50 basis points (see, e.g., Acharya et al. 2015, Bahaj 2013, Hajres 2011, Neri and Ropele 2013, Zoli 2013).

The main features of a macro model of the sovereign risk channel are quite realistic and consistent with the evidence from the Eurozone and elsewhere. Markets charge higher risk premia to countries with a higher (current and future path of) public debt. Private firms’ borrowing costs rise by some fraction of the increase in risk premia.

In this context, consider the possibility that market participants become arbitrarily pessimistic regarding a country’s growth. For a given monetary policy and a given exchange rate, markets forecast a fall in economic activity and a deterioration of public finances consistent with their expectations. To the extent that this deterioration translates into anticipations of higher prospective deficits and debt, risk premia on government debt then peak already in the short run, driving up (through the sovereign risk channel) private borrowing costs.4 As a result, economic activity falls on impact, so validating the initial arbitrarily adverse expectations.

Countries with high debt, like Italy, are obviously particularly vulnerable to a belief-driven downturn and sovereign risk crises of this kind. It is worth stressing that what matters for this channel to operate is the prospective (not current) debt level, thus including contingent and future liabilities.

Rebuilding trust and cohesion

After 2010, financial instability grew steadily in the Eurozone in large part reflecting insufficient development of EZ institutions and cooperative policies able to shield the member countries from self-fulfilling crises and bring the system to correct the ‘imbalances’ at the root of the instability. The two goals are strictly interrelated.

A widespread view created a political hurdle. This is the view that shielding a country from speculation would water down the incentive to implement reforms and correct imbalances.

In this respect, there is a valuable contribution from the literature on the international lender of last resort that is lost in translation.5 The point is that there is a key difference between the moral hazard implications of bailouts and transfers implied by insurance, and the incentive effects of a pure backstop.

  • In an insurance scheme, ex-post bailout/transfers have strictly positive probability.

They reduce reform efforts by diluting the link between costly policies and their future benefits.

  • A pure backstop strategy does not require a transfer of resources with positive probability.

The strategy works via a credible commitment to carry out interventions off-equilibrium, i.e., in response to belief-driven speculative attacks that, if the strategy is successful, never occur.

While the short-run costs of national reforms, in political and economic terms, are immediately felt, the expected benefits from them may be at stake if belief-driven speculative attacks can at any point in time worsen the country’s macroeconomic and financial outlook. Under these circumstances, a backstop to government debt that shields a country from arbitrary and disruptive speculative behaviour, improves the expected benefits from reforms relative to their costs.

In other words, by ruling out the possibility of a crisis and downturn driven by arbitrary expectations, a backstop strengthens the incentives for governments to undertake costly corrections of its fundamental imbalances (see Corsetti and Dedola 2011 for a formal analysis).

This is not to deny the risk of moral hazard from the practical implementation of a backstop strategy. It is well understood that the difference between fundamental and belief-driven crises is not well defined. Moreover, the objective function of the incumbent government may have partisan or private objectives, which bias its willingness to take the ‘right’ action. But exactly for these considerations, in practice, backstop strategies can work well provided that EZ institutions are developed enough to enforce some reasonable form of conditionality and sufficiently strict rules about what qualifies a country for support. In many respects, the ECB’s OMT programme has been designed to address exactly these prerequisites.

Despite the success of the OMT in 2012, a credible stand by the ECB on sovereign debt is only one piece of the complex institutional puzzle still on the table. Institutional and policy uncertainty about banking union, fiscal rules, debt crisis management, and the general prospect for consolidation of the Eurozone remain high, and the policy conflict still quite strong.

Unfortunately, while other areas in the world with a higher debt level – at the outburst of the crisis or even now – seem to have returned to a path of growth and recovery, letting the risk-premia genie out of the bottle appears to have created a difficult inheritance for European citizens. Debt and debt overhang can be expected to condition policymaking for years to come, even if, arguably, there could be other areas where interventions could be most productive.

Author's note: I thank Riccardo Trezzi for comments, and especially for suggesting the graphs in Figure 1, and Anil Ari and Samuel Mann for excellent research assistance and comments. The text draws on my work as Duisenberg Fellow at the Netherlands Institute for Advanced Study in the Humanities and Social Sciences in Wassenaar in 2012.


Acharya V, T Eisert, C Eufinger, and C Hirsch (2015), “Real Effects of the Sovereign Debt Crisis in Europe: Evidence from Syndicated Loans”, Mimeo

Ari A (2015) ''Sovereign Risk and Bank Risk-Taking'' OeNB Working Paper No. 202

Bahaj S (2013), “Systemic Sovereign Risk: Macroeconomic Implications in the Eurozone”, mimeo, Cambridge University

Brunnermeier, M, L Garicano, P Lane, M Pagano, R Reis, T Santos, S Van Nieuwerburgh, and D Vayanos (2011), “European Safe Bonds: ESBies”,

Calvo G (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review 78(4), 647-661

Cole, H L and T Kehoe (2000), “Self-Fulfilling Debt Crises”, Review of Economic Studies, 67, 91-116.

Corsetti G and L Dedola (2011), “Fiscal Crises, Confidence and Default: A Bare-bones Model with Lessons for the Eurozone”, mimeo, Cambridge University 

Corsetti G and L Dedola (2013), “The mystery of the printing press: self-fulfilling debt crises and monetary sovereignty”, CEPR Discussion Paper 9358

Corsetti G, K Kuester, A Meier and G Mueller (2013a), “Sovereign Risk, Fiscal Policy, and Macroeconomic Stability”, Economic Journal, February, F99-F132.

Corsetti G, K Kuester, A Meier and G Mueller (2013b), “Sovereign risk and belief-driven fluctuations in the Eurozone”, forthcoming, Journal of Monetary Economics.

Corsetti G, B Guimaraes and N Roubini (2005), “International lending of last resort and moral hazard: A model of IMF catalytic Finance”, Journal of Monetary Economics, 53(3), 441-471.

Fisher S (1999), “On the Need for an International Lender of Last Resort”, Journal of Economic Perspectives, 13(4) 85-104.

Harjes, T (2011), “Financial Integration and Corporate Funding Costs in Europe After the Financial and Sovereign Debt Crisis”, in: ‘IMF Country Report No. 11/186,’ International Monetary Fund.

Mertens, K and M Ravn (2010), “Fiscal Policy in an Expectations Driven Liquidity Trap”, CEPR Discussion Paper 7931.

Morris S and H S Shin (2006), “Catalytic Finance: When Does it Work?” Journal of International Economics, 70(1), 161-177.

Neri, S (2013), “The Impact of the Sovereign Debt Crisis on Bank Lending Rates in the Eurozone”, mimeo, Banca d’Italia.

Neri, S and T Ropele (2013), “The Macroeconomic Effects of the Sovereign Debt Crisis in the Eurozone”, mimeo, Banca d’Italia.

Obstfeld, M (1995), “Models of Currency Crises with Self-Fulfilling Features”, European Economic Review 40, 1037-47.

Zoli, E (2013), “Italian Sovereign Spreads: Their Determinants and Pass-through to Bank Funding Costs and Lending Conditions”, IMF Working Paper 13/84.


1 In Italy, past reforms of the social security system and a relatively low exposure of the banking system to dubious international assets reduced the size of contingent public liabilities.

2 The list does not include runaway inflation, as this would be better described as a manifestation of the high debt problem, rather than a solution to the problem.

3 As shown by Calvo (1988) and Cole and Kehoe (2000) for the case of a country operating on its own, what enables financial markets to launch successful speculative attacks on sovereign debt based on expectations of fiscal fragilities is the absence of a credible policy and a budget regime to anchor expectations. It is exactly because policy credibility is imperfect that, in equilibrium, expectations of a crisis unrelated to fundamentals are bound to be validated ex post by actual budget and macroeconomic developments. A similar argument is put forward by Obstfeld (1995) for currency crisis.

4 The channel would not be consequential if monetary policy offset a rise in risk premia with interest rate cuts, consistent with the monetary prescription by Curdia and Woodford. In the presence of constraints on monetary policy (say, policy rates are at the zero lower bound), Corsetti et al. (2013a) also assesses the scope for imperfectly credible fiscal authorities to lean against speculative behaviour, by engineering pro-cyclical budget cuts; only under very strict conditions, can this reaction sever the link between expectations of a downturn and anticipations of higher deficits. In general, pro-cyclical cuts are not an effective strategy.

5 See Chari and Kehoe (1998), Fisher (1999), Morris and Shin (2005), Corsetti et al. (2006), among many others



Topics:  EU policies Global crisis Macroeconomic policy

Tags:  EZ crisis, EZ institutional flaws, Debt crisis, EU institutions, policy credibility

Professor of Macroeconomics, University of Cambridge and Programme Director, CEPR