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COMMON FATE, COMMON FUTURE

Permanent Link: http://ncf.sobek.ufl.edu/NCFE004760/00001

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Title: COMMON FATE, COMMON FUTURE STRUCTURAL ORIGINS OF THE EURO CRISIS
Physical Description: Book
Language: English
Creator: Filmyer, Roger
Publisher: New College of Florida
Place of Publication: Sarasota, Fla.
Creation Date: 2013
Publication Date: 2013

Subjects

Subjects / Keywords: Euro Crisi
EU
Optimal Currency Areas
Fiscal Union
Genre: bibliography   ( marcgt )
theses   ( marcgt )
government publication (state, provincial, terriorial, dependent)   ( marcgt )
born-digital   ( sobekcm )
Electronic Thesis or Dissertation

Notes

Abstract: This thesis analyzes the Euro Crisis by looking at the institutions of the EU and characteristics of the Eurozone's economy. Chapter 1 looks at Optimal Currency Theory (the theoretical underpinning of the Euro), evaluates the suitability of the Eurozone as an Optimal Currency Area, and discusses Endogenous OCA Theory and Neo-Chartalism as alternative theoretical approaches to currency union. Chapter 2 explores three crises of euro governance: the sudden initial depreciation, the 2003 Stability and Growth Pact (SGP) Crisis, and the failure of the Eurozone banking system in 2009. Additionally, it addresses the worsening environment for European Integration in the wake of the Euro Crisis. Chapter 3 considers the consequences of Eurozone breakup and proposes three solutions: Banking Union, Fiscal Union, and Political Union.
Statement of Responsibility: by Roger Filmyer
Thesis: Thesis (B.A.) -- New College of Florida, 2013
Electronic Access: RESTRICTED TO NCF STUDENTS, STAFF, FACULTY, AND ON-CAMPUS USE
Bibliography: Includes bibliographical references.
Source of Description: This bibliographic record is available under the Creative Commons CC0 public domain dedication. The New College of Florida Libraries, as creator of this bibliographic record, has waived all rights to it worldwide under copyright law, including all related and neighboring rights, to the extent allowed by law.
Local: Faculty Sponsor: Khemraj, Tarron

Record Information

Source Institution: New College of Florida
Holding Location: New College of Florida
Rights Management: Applicable rights reserved.
Classification: local - S.T. 2013 F4
System ID: NCFE004760:00001

Permanent Link: http://ncf.sobek.ufl.edu/NCFE004760/00001

Material Information

Title: COMMON FATE, COMMON FUTURE STRUCTURAL ORIGINS OF THE EURO CRISIS
Physical Description: Book
Language: English
Creator: Filmyer, Roger
Publisher: New College of Florida
Place of Publication: Sarasota, Fla.
Creation Date: 2013
Publication Date: 2013

Subjects

Subjects / Keywords: Euro Crisi
EU
Optimal Currency Areas
Fiscal Union
Genre: bibliography   ( marcgt )
theses   ( marcgt )
government publication (state, provincial, terriorial, dependent)   ( marcgt )
born-digital   ( sobekcm )
Electronic Thesis or Dissertation

Notes

Abstract: This thesis analyzes the Euro Crisis by looking at the institutions of the EU and characteristics of the Eurozone's economy. Chapter 1 looks at Optimal Currency Theory (the theoretical underpinning of the Euro), evaluates the suitability of the Eurozone as an Optimal Currency Area, and discusses Endogenous OCA Theory and Neo-Chartalism as alternative theoretical approaches to currency union. Chapter 2 explores three crises of euro governance: the sudden initial depreciation, the 2003 Stability and Growth Pact (SGP) Crisis, and the failure of the Eurozone banking system in 2009. Additionally, it addresses the worsening environment for European Integration in the wake of the Euro Crisis. Chapter 3 considers the consequences of Eurozone breakup and proposes three solutions: Banking Union, Fiscal Union, and Political Union.
Statement of Responsibility: by Roger Filmyer
Thesis: Thesis (B.A.) -- New College of Florida, 2013
Electronic Access: RESTRICTED TO NCF STUDENTS, STAFF, FACULTY, AND ON-CAMPUS USE
Bibliography: Includes bibliographical references.
Source of Description: This bibliographic record is available under the Creative Commons CC0 public domain dedication. The New College of Florida Libraries, as creator of this bibliographic record, has waived all rights to it worldwide under copyright law, including all related and neighboring rights, to the extent allowed by law.
Local: Faculty Sponsor: Khemraj, Tarron

Record Information

Source Institution: New College of Florida
Holding Location: New College of Florida
Rights Management: Applicable rights reserved.
Classification: local - S.T. 2013 F4
System ID: NCFE004760:00001


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COMMON FATE, COMMON FUTURE: STRUCTURAL ORIGINS OF THE EURO CRISIS BY ROGER FILMYER A Thesis Submitted to the Division of Social Sciences New College of Florida in partial fulfillment of the requirements for the degree Bachelor of Arts Under the sponsorship of Dr. Tarron Khemraj Sarasota, Florida May, 2013

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ii Acknowledgements To Prof. Khemraj, for giving me the original idea for this thesis, helping me through the thesis process, and for advising me over the past two years. To Prof. Hicks, for setting me straight for the two years before that. To Profs. Van Horn and Alcock, for sitting on my committee. Finally, t o my pare nts, Robin Pugh and Bill Filmyer, for supporting me (emotionally and financially) through my four years at New College.

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iii Table of Contents Acknowledgements ................................ ................................ ............ ii List of Figures and Tables ................................ ................................ .. iv Abstract ................................ ................................ .............................. v Introduction ................................ ................................ ....................... 1 Background ................................ ................................ ................................ .................. 3 Chapter 1 Economic Problems ................................ ........................ 6 Optimum Currency Areas ................................ ................................ ......... 7 Flows ................................ ................................ ................................ ........ 9 Labor Mobility ................................ ................................ ................................ .............. 9 Trade ................................ ................................ ................................ ............................ 12 Fiscal Flows ................................ ................................ ................................ ................. 15 Shock Symmetry ................................ ................................ ..................... 15 Has it changed? ................................ ................................ ....................... 19 Alternatives to the OCA Model ................................ ................................ 21 Endogenous OCA Theory ................................ ................................ ........................... 22 Neo Chartalism ................................ ................................ ................................ .......... 24 Conclusion ................................ ................................ .............................. 27 Chapter 2 Pol itical Discord ................................ ............................ 29 A lack of strong policy ................................ ................................ ............. 30 Exchange Rates ................................ ................................ ................................ ........... 31 Credibility and the SGP ................................ ................................ .............................. 35 EU Banking System, National Regulation ................................ ................................ 38 A lack of political unity ................................ ................................ ............ 42 The Problems of Engagement ................................ ................................ .................... 43 Short Term Procyclical Support ................................ ................................ ................ 46 Conclusion ................................ ................................ .............................. 48 Chapter 3 Solutions ................................ ................................ ....... 49 Breakup ................................ ................................ ................................ .. 49 Banking Union ................................ ................................ ........................ 52 Fiscal Union ................................ ................................ ............................ 55 Political Union ................................ ................................ ........................ 58 Conclusion ................................ ................................ .............................. 61 Conclusion ................................ ................................ ....................... 62 Recent Developments and Future Possibilities ................................ ......................... 63 Bibliography ................................ ................................ ..................... 65

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iv List of Figures and Tables Figure 1.1: Map of Intra EU trade by Member State ................................ ................ 14 Figure 1.2: US Domestic commerce vs. Intra EU trade as % of GDP, 2000 2011 ...... 14 Figure 1.3: Karras's Results on Country Specific Shocks in Europe ........................ 16 Figure 2.1: Value of Euro in US Dollars, 1999 2004 ................................ ................ 31 Figure 2.2: National Identity in the EU, 19 92 2010 ................................ ................ 45 Figure 2.3: EU Net Support vs. Real GDP Growth, 1998 2009 ................................ 47 Figure 3.1: Responsibilities of the Single Supervisory Mechanism ......................... 54 Table 1.1: Country specific shocks in Europe vs EU15 and EU28, 1991 2011 ........... 20

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v Abstract This thesis analyzes the Euro Crisis by looking at the institutions of the EU and characteristics of the Eurozone's economy. Chapter 1 looks at Optimal Currency Theory (the theoretical underpinning of the Euro), evaluates the suitability of the Eurozone as an Optimal Currency Area, and discusses Endogenous OCA Theory and Neo Chartalism as alternative theoretical approaches to currency un ion. Chapter 2 explores three crises of euro governance: the sudden initial depreciation, the 2003 Stability and Growth Pact (SGP) Crisis, and the failure of the Eurozone banking system in 2009. Additionally, it addresses the worsening environment for Euro pean Integration in the wake of the Euro Crisis. Chapter 3 considers the consequences of Eurozone breakup and proposes three solutions: Banking Union, Fiscal Union, and Political Union. Professor Tarron Khemraj Division of Social Sciences

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1 Int roduction In 2007, a housing bubble in the United States popped and home prices started declining. Many homeowners foreclosed, which left banks with large numbers of bad loans. Since it was unclear how badly individual banks were exposed to bad mortgages, the interbank loan market collapsed. The interbank market collapse affected European banks as well as American ones, especially in Ireland and Spain. Both of these countries were experiencing similar housing bubbles, and the collapse triggered these bubble s to pop as well. In order to rescue Ireland's banking sector, the government decided to guarantee all Irish bank liabilities, at a cost of over 100% of Irish GDP. In 2009, the new Greek prime minister revealed that Greece had been falsifying its budget fi gures and that Greece's deficit was twice as high as originally thought. The global financial crisis d rew attention to the perilous position of the Eurozone's "peripheral" countries. 1 By 2010, five countries were experiencing sovereign debt problems: Port ugal, Ireland, Italy, Greece, and Spain. The dominant narrative of the Euro Crisis holds that the troubled countries were at fault for their debt problems due to prior fiscal irresponsibility 1 Many analyses of the Euro define a "Core" Eurozone, made up of Germany and Northern Europe (e.g. Austria, Belgium, Netherlands, Luxembourg, and possibly France and Finland). The other countries make up the less developed "Periphery". The boundaries of these regions are contested, as is the terminology itself.

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2 (Caporaso and Kim 2012) To illustrate this, the countries were popularly called "PIIGS" (an acronym of the names of each of the five countries). However, the Euro Crisis represented a problem with the union, not with its parts. The sovereign debt crises were largely symptoms of structural deficiencies within the Euroz one. This thesis will evaluate how the formation of EU institutions and structure of the Eurozone's economy caused the Euro Crisis Chapter 1 evaluates the economic suitability of the euro. The euro is an application of Mundell's Optimal Currency Theory, which differentiates between political borders and Optimal Currency Areas Regions that are suitable for currency unions exhibit highly symmetric economic shocks and have high internally mobile capital and labor flows. Given these criteria, the Eurozone is poorly suited for currency union and is destined to experience periodic currency crises. Chapter 2 analyzes the political institutions supporting the euro. In addition to an economic project, the euro was used as a European political symbol. The euro wo uld have not survived without strong political support for an integrated Europe. This chapter identifies failures in the adaptability and setup of political institutions and erosions in political unity. Chapter 3 provides an overview of possible institutional reforms to strengthen the euro and discusses their suitability. While there is general consensus on the unsustainability of the status quo proposed solutions range from the complete breakup of the E urozone to substantial integration. Three major institutional reforms are proposed: Banking union, Fiscal union, and Political union.

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3 Background In 1951, six countries in Western Europe signed a trade agreement to create a common market for coal and steel. The European Coal and Steel Community was the first step in a series of international agreements to unify Europe economically and politically. The European Economic Community (EEC) and the European Atomic Energy Community (EURATOM) joined the ECSC in the 1957 Treaty of Rome. These treaties encouraged intra European trade not only for its economic benefits, but also to foster postwar peace. By pooling the markets of France, Germany, Italy and the Benelux countries (Belgium, the Netherlands, and Luxembourg) the creators of this agreement sought to prevent war and give the countries of Europe a common interest in cooperation (Blair 2010) Over the next thirty years, other European countries became members of the three European Communities. The Communities cre ated more opportunities for economic integration with the European Free Trade Area and the European Customs Union. This change was incremental and slow paced, set back by the 1965 "vacant seat" crisis and economic crisis in the 1970s. But in the ten years from 1985 to 1995, Europe undertook three major reforms: t he creation of a Single European, a Single Market, and a Single Currency. These reforms marked a new era for an integrated Europe. The 1985 Schengen Agreement created a system of free movement acros s national borders. The Single European Act set the path for a Single Market in the European Economic Area. And the 1991 Treaty of Maastricht transformed the institutions of Europe. It merged the three communities into a European Union and created the Eco nomic and Monetary Union (EMU).

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4 At the same time as these political reforms, Europe tried to create a monetary union. From World War II until 1971, the countries of Western Europe were members of the Bretton Woods system. This exchange rate regime had coun tries fix the exchange rate of their currencies to the US dollar, which was backed by gold. When the United States abandoned the gold standard in response to rising inflation, Western Europe responded by unfixing their exchange rates. Instead, Europe creat ed its own currency schemes. These projects were largely unsuccessful; the 1972 "Snake in the Tunnel" failed, as did the European Monetary System. The Economic and Monetary U nion was different from the exchange rate regimes. Instead of creating a system of fixed exchange rates, it created a single currency, the euro. The euro came with a new European Central Bank to manage the currency, Cohesion Funds to allow less developed countries to catch up, and (at Germany's insistence) a rigorous set of fiscal restr aints as entrance criteria. The Maastricht treaty set the date for adoption at January 1, 1999. By 1997, it looked like the euro would not come to fruition. Scholarly consensus found that the euro was not economically viable, and none of the candidate coun tries 2 complied with the so called Maastricht criteria. B ut within a year, all of these M ember S tates took great pains to lower their budget deficits. The next fall, the European Commission recommended that all except Greece adopt the Euro on time. Just as the European Communities, the euro was as 2 The twelve Euro candidate countries were Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the N etherlands, Spain, and Portugal

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5 much of an economic tool as a political one. Countries took great pains to be part of this tangible symbol of integrated Europe. The late 2000s were as ambitious as the late 1980s. In 2004, ten countries joined th e EU (including seven from the former Warsaw Pact). 3 The EU constitution in 2005 was a failed attempt to consolidate the different treaties of the EU, but the 2009 Treaty of Lisbon gave the EU power over more areas and strengthened the European Parliament. 3 The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Cyprus, Malta, Slovenia, with the first 7 being former members of the Warsaw pact.

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6 Chapter 1 Economic Problems By the middle of the 1780s, the nascent United States of America had found itself at a crossroads. The states were part of a "perpetual union ," and their foreign affairs were managed by the new national government. But as a confeder ation, acts could only be passed by unanimous consent of the states. This led to a weak national government that simultaneously alienated members who wanted stronger, more autonomous states, while disappointing "federalists" like Thomas Jefferson and Alexa nder Hamilton who wanted a powerful national government. The existing arrangement became unworkable, as the United States was unable to establish a military, regulate foreign commerce, or perform other basic functions over the objections of a few individua l states The Founding Fathers resolved this dilemma by radically restructuring the US government and drafting a new document, the US Constitution, which shared sovereignty between the states and the federal government and gave ultimate authority over inte rstate and national affairs to the federal government. Today, the nascent European Union and European Central Bank (ECB) have found themselves at a similar crossroads. Europe's internal market is not unified enough to support a strong single currency, the ECB is ill suited to manage all of E urope, and the Eurozone's structure cannot remediate imbalances

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7 in local economies. The Eurozone sits in an "uncanny valley" of integration, where the system can transmit shocks from count ry to country but the mitigation framework is ineffective The system is in long term transition, but cannot be expected to last if it cannot withstand short term issues. Europe 's economy must integrate further if the euro is expected to last Optimum Currency Areas Much of the theoretical backing for the Euro is in the concept of the Optimum Currency Area (OCA), first put forth by Robert Mundell in 1961. The concept emerged as a response to the Bretton Woods system. Mundell conceded that his idea was not universally applicable, but he argued that a floating rate regime would not be advisable everywhere. He proposed that there were regions independent of national borders that would mak e the best common currency areas areas with a single currency and central bank. Thes e hypothetical regions were larger than states, and involved the complete cessation of authority to a new central bank. This idea of currency areas attempted to strike a balance between fixed and floating exchange rate regimes. The existing system of fixed exchange rates caused problems for countries with an imbalance in their current account, where current account (Mundell used the term "external balance") deficits led to unemployment and current account surpluses led to inflation. Additionally, when count ries ran out of foreign exchange reserves, they were vulnerable to attacks on their currency a nd to balance of payment crises (Mundell 1961; 657) As an alternative to fixed rates currencies could "float" in relation to each other, trading freely against each other, with the exchange rate determined by the open

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8 market. This system made trade and capital imbalances easier to resolve ; a currency could depreciate instead of causing unemployment, and a currency could appreciate instead of creating inflation A t the sa me time, Mundell argued it was un necessary for all countries to have flexible exchange rates. Since fixed exchange rates were the universal norm at the time of his paper, he only briefly mentioned the reasons why countries chose fixed exchange rate s. While flexible exchange rates are better able to resolve trade imbalances fixed exchange rates are superior when the current account is more stable. Fixed exchange rates mean that exchange rates will not vary, so firms doing business internationally do not have to worry about exchange rate risk Mundell advocated a sort of currency regionalism, where pockets of economically similar areas would have a single currency, which was free to float against the currency of other regions. In his paper, these regio ns existed completely independently of national borders and could even be parts of countries. These optimum currency areas consist of regions that have a high degree of factor mobility internall y but limited external mobility (Mundell 1961 ; 661) A region that has a large amount of capital and labor flowing beyond its borders is incomplete, and a region with little intra regional flow is too large and will lend itself to the problems of a fixed exchange rate regime. Even in 1961, there was talk of a single currency uniting the six countries of the Common Market (Germany, France, Italy, The Netherlands, Belgium, and Luxembourg). Mundell was the first to reduce this debate to a single empirical question: Does

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9 the Common Market have a high internal mobility of labor and capital, relative to the rest of the world? Flows The creation of a single market has been an underlying goal for European integration efforts from the very beginning. The European Union like the European Community before it, has put a conside rable amount of effort into increasing the mobility of labor and capital. Through efforts such as the lowering of tariff barriers, adoption of common regulations, and eventually the creation of a common currency and virtual elimination of border controls, Europe has done what a few decades ago would be unthinkable in order to create a unified economy. Despite this progress, there are still substantial barriers to an economically integrated Europe. European labor is incredibly immobile, even within national borders. Migration across a 27 state union remains the exception rather than the rule. Intra EU (and by proxy intra Eurozone) trade is at a lower level than other large economies and has not increased in the past decade. And the fiscal unity present in oth er large economies is nearly absent in Europe. Fiscal aid and labor migration only flow slowly in order to gradually deal with structural disparities, rather than flowing quickly in order to stabilize a regional economic shock. Labor Mobility After sovereign debt crises, the most visible effect of the Euro C risis is in high levels of unemployment. The most recent figures give Spain and Greece a 2 7 % unemployment rate. Yet at the same time, Germany is at 5. 4 %, a figure that Spain do es not reach even i n good times (Eurostat) The incredibly fragmented

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10 labor market of Europe is one of the EU's great challenges D espite efforts to ease statutory barriers workers still move slowly and steadily. Labor demand shocks tend to be more regional in E urope than i n the United States (Decressin and Fat‡s 1995 ; 1649) In other words, while the US's labor shocks tend to be felt nationwide, the EU's shocks are not felt community wide. This makes stabilization policy difficult, as when the European Central Bank acts it will be forced to make a choice between price stability and unemployment that will not be optimal for all Eurozone countries. Either some countries will not get as much help as they need or some countries will have to accept a higher rate of inflation than necessary. Additionally, Americans are much more willing to migrate than their European brethren. According to Eichengreen (1993 ; 131), "Americans move between US states about three times as frequently as Frenchmen move between dŽpartements and Germans mo ve between lander. M igration between European countries is even less common In fact, when Europeans do migrate between countries, it is in steady flows "driven by structural disparities between regions rat her than by labor demand shocks ( Decressin and F at‡s 1995; 1647) The largest change in intra EU migration came from the 2004 accession of CEECs. The UK, for example, had over seven hundred thousand migrants f rom Central and Eastern Europe from 2004 2007 (Dobson 2009) The migrants tended to be young and well educated attracted by higher pay and lower rates of unemployment (both reflective of structural disparities within Europe). However, these workers were not conventional migrants. They did not intend to permanently settle in their new countries, but came during a break in university

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11 studies (whether a summer or gap year) seeking better pay for a temporary job. The jobs these students held were low wage service or agricultural positions, often seasonal. With Europe 's considerable linguistic and cultural barriers, only those with a functional command of a foreign language and the flexibility to deal with new environments could migrate effectively. Accordingly, East West migration accounted for 2% or less of the labor force of Western European countries. (Dobson 2009) When the demand for labor in Europe shrinks, the European labor force shrinks to compensate. But since workers do not move, the primary method of shrinking the labor force is in reducing participation. F or example, when firms in Germany shrink their workforce, they usually negotiate an early retirement package for older employee s with their union counterparts ( Decressin and Fat‡s 1995; 1648) This fragmentation leads to problems for Europe wide stabilizat ion policy. Since shocks tend to be regional, the ECB is forced into poorly fittin g a one size fits all policy on to different regions with different economic conditions. C ompounding the problem are the different policy choices in the formation of the Euro. In the United States, the Federal Reserve is governed by a "dual mandate" of price stability (through inflation targeting) and employment stability, so when the unemployment rate increases, the Fe d will generally cut interest rates to mitigate the labor shock. But the Eurozone does not have this option The charter of the ECB reflects a German preoccupation with price stability, and inflation is

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12 the Central Bank's main concern. As such regions tha t experience labor shocks will not get aid from the Central Bank Trade The European Union has had more success creating interconnected trade networks The Single Market has proven to be a powerful tool for the EU, encouraging existing members to integra te further as well as enticing non members in Europe to join. Intra EU trade accounts for 64% of Europ e's exports, and 61% of imports (Eurostat) The problem here is not in the lack of existing progress, but in the lack of further improvement. The figure h as been mostly stagnant over the past ten years, despite a blistering pace of integration. The Euro's convenience in trade is one of the largest reasons for countries to adopt it, and if the Euro is going to involve a larger commitment from countries, intr a EU trade must grow as well. In the years leading up to the Euro's formation, the prospects for integration did not look good The 1992 3 ERM crises led to the United Kingdom's exit from the Euro's predecessor and cast doubt on the viability of a system o f stable exchange rates, let alone a single currency. In 1997, two years from the target for the Euro's introduction, no country was in complete compliance with the Maastricht criteria, a set of fiscal guidelines (Garrett 1997 ; 22) But just a year later, all of the twelve Euro candidates were either in compliance or on their way. The European Commission's 1998 Convergence Report effusively opened:

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13 In a few months from now, the euro will be a reality. By creating the single currency, Europe will be offering its citizens, its children and its partners in the wider world a more concrete symbol of the common destiny it has freely chosen: that of building a community based on peace and prosperity (1998 Convergence Report) This appraisal was in stark contrast to the more pessimistic outlook from the 1996 report and lauded the "political resolve" of member nations to meet the stringent budget criteria. This political resolve came from not only a "culture of stability" or other nebulous notions of identity, but als o a belief in the concrete benefits of improved trade. In the precursors to the Euro, such as the ERM and the "snake in the tunnel" of the early 1970s, the countries that stayed the most committed to the exchange rate projects were those that had the stron gest trade links with the rest of Europe (Frieden 1996; 209) In the "trilemma" of international economics, where countries are forced to sacrifice free capital flows, stable exchange rates, or independent monetary policy in order to ensure the other two, these interlinked countries were more amenable to relinquishing monetary policy in order to guarantee a system of stable exchange rates. The arrival of the Euro crisis, however, tests the political will of Euro members more than ever. And trade linkages h ave not improved since the Euro's introduction. That is not to say that they are low over 60% of EU imports and exports are to other EU countries. But they are not high either (Eurostat) Compared to the US, where 80% of goods and services are consumed do mestically, there is room for improvement (FRED) I t is concerning that there has been no real change over the past ten years.

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14 Figure 1 1 : Map of Intra EU trade by Member State Source: Eurostat Figure 1 2 : US Domestic commerce vs Intra EU trade as % of GDP, 2000 2011 Source: US data from FRED, EU data from Eurostat

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15 Fiscal Flows Many economists suggest that the Euro's monetary union should be coupled with a fiscal union as well. Eichengreen (1992 ; 32) suggested that fiscal transfers could be used if EU M ember S tates' hands were tied by statutory obligations, or if factors of production (i.e. labor and capital) were not sufficiently mobile. He estimated tha t the federal government offsets "roughly 35 percent of a state's income loss when it experiences a recession ," and argued that a fiscal union's "absence from the Maastricht Treaty will complicate regional problems following the transition to EMU." But whi le the US's government spending accounts for 39% of GDP, the EU 's budget is relatively negligible accounting for less than 1% of GDP (t he national governments account for an average of 46% of GDP) (Eurostat) Additionally, these limited funds are often gi ven out in the form of Cohesion or Structural funds, which give long term development aid to less well off regions like the CEECs or the rural south of Spain (DomŽnech 2000 ; 632) There is no emphasis given towards stabilization, and no infrastructure t o deal with short term shocks. Shock Symmetry Researchers after Mundell have reframed his simple question into a number of criteria and an encompassing cost benefit analysis. These criteria center on the tradeoff between reduced transaction costs and a more credible central bank, versus the loss of independent monetary policy (which makes stabilization much more difficult). Karras determined that this tradeoff revolves around a question of economic sh ocks; where as countries that have economic

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16 shocks that coincide with the union at large will have little to lose from integrating, economies that have out of sync business cycles should be more wary of entering a currency union (Karras 1996; 366) Karras then evaluated this tradeoff by comparing the shocks of European countries to the shocks of Europe's economy as a whole. In his words, he wanted to observe economy specific shocks and screen out common ones. If most economies had small economy speci fic shocks, then the cost of monetary union would be low. But if this were not the case; if some countries were in panic while others were completely unaffected, then a monetary union would be difficult to manage. Figure 1 3 : Karras's Results on Country Specific Shocks in Europe Reproduced from : Karras, Georgios. "Is Europe an optimum currency area? Evidence on the magnitude and asymmetry of common and country specific shocks in 20 European countries." Journ al of Economic Integration (1996): 366 384.

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17 Karras found that almost all of the countries in the EU were out of sync. With the exceptions of France and Belgium, all of Europe experienced economy specific shocks that were more volatile than the common shock s. In an extreme case, Cyprus's shocks were twenty one times m ore volatile than common shocks (Karras 1996; 374) If anything, the study found positive signs for smaller regional currencies, with Belgium, France, and Spain and Norway, Finland, and Sweden h aving positively correlated shocks. Similarly, Bayoumi and Eichengreen focused on comparing the severity of shocks of different countries in the then European Community in a hypothetical monetary union to those of similarly sized US regions (as defined by the U.S. Bureau of Economic Analysis). They tested the integration of economies on two fronts: the correlation of growth and inflation rates, and the size of demand and supply shocks. The authors posited that in an optimal currency area, the numbers would be closely correlated, and shocks would be smaller (Bayoumi and Eichengreen 1992; 17) The first thing that the researchers noted is that both the US and Europe could be divided into a "core" region and a "periphery", with the core consisting of regions/co untries of similar behavior, while the periphery had a looser relation to the union. The US core consisted of the Mid East, New England, Great Lakes, and Southeast regions, and the European core consisted of Germany, France, Belgium, the Netherlands, Denma rk, and Luxembourg (Bayoumi and Eichengreen 1992; 27) The distinction, however, is less marked in US regions than in Europe.

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18 Bayoumi and Eichengreen found a result that could be expected: that US regions had more closely correlated demand shocks than Euro pean countries. The researchers found a marked difference between the correlations of US regions and European countries as a whole, but found that the demand shocks of core European countries were similar to those of the US as a whole. Additionally, they s peculated that some of the similarity could be explained by the existence of a single currency and a uniform economic policy ( Bayoumi and Eichengreen 1992 ) When the researchers examined the size of shocks, however, they found that demand shocks were large r in US regions than in European countries. This effect was not an increased volatility in the at large US economy (which was less volatile than Europe's), but rather in the volatility in regions. They were surprised at this con clusion, assuming that the more tightly integrated regions would have smaller shocks. They attributed this difference to regional specialization; since the regions were so tightly integrated, they were able to specialize in cer tain industries while the sti ll disjointed European countries had to maintain diversified economies. The researchers found that there was not a strong distinction between a US core and periphery, while Europe had a marked distinction the peripheral nations had double the standard dev iation of the core nations (1 2%/year for core countries compared to 2 4%/year for the periphery) (Bayoumi and Eichengreen 1992 ; 33) Bayoumi and Eichengreen drew the conclusion that, with less of a relationship between countries in Europe, a monetary unio n would be less manageable than the US's union. The existence of such a marked core meant that

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19 getting a union to accommodate the needs of the periphery would lead to resistance from core countries. Additionally, one of the costs of integration, with an in crease in industrial specialization, would be the increase of demand shocks. Has it changed? Of course, there exists the possibility that the economies of Europe may have undergone a radical restructuring, just like their governments did in preparation fo r accession to the EU and adoption of the euro. An update may be in order, as Karras's and Bayoumi and Eichengreen's studies were conducted more than fifteen years ago. In order to test if this radical restructuring has occurred I replicated Karras's stud y with a more modern set of data, from 1990 to 2010. Like Karras, I evaluated the magnitude and correlation of country specific shocks, in order to see whether Karras's pessimism on economic grounds for monetary union was still warranted. This dataset incl udes only one business cycle, so a future study could be done ten or twenty years down the road for more robust shock data. Of course, integration has been proceeding so quickly that the European economies seen in the future could be radically different fr om their current counterparts. Since Karras's study, the landscape of European integration has changed dramatically. Central and Eastern European Countries (CEECs) have been joining the EU, first en masse in 2004, and later as a trickle in 2007. With the n early inevitable accession of Croatia in June of this year, it seemed logical to conduct this survey not only in regards to the EU15 of Karras's day, but the soon to be EU28. But these new members bring complications into the data. After all, at the beginn ing of the surveyed time period, these new members su ffered

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20 profound economic damage. Not only did the collapse of the Soviet Union disrupt the CEECs' economies by eliminating a key source of aid to these satellite states, but also their transition to capi talism, which left the CEECs' agriculture sectors to compete against a subsidized EU Table 1 1 : Country specific shocks in Europe vs EU15 and EU28, 1991 2011 Country vs. EU15 vs. EU28 vs. EU28 adjusted Rank (EU15) Rank 2 (EU28 adj.) Austria* 1.04 1.04 5 5 Belgium* 0.68 0.68 1 1 Bulgaria 11.37 11.37 6.63 26 27 Croatia 14.25 14.25 3.81 30 22 Cyprus* 2.76 2.76 15 17 Czech R.* 6.85 6.86 2.35 23 15 Denmark** 2.11 2.11 11 13 Estonia* 26.45 26.46 11.76 32 30 Finland* 5.36 5.37 3.59 18 21 F ran ce* 0.73 0.73 3 3 Germany* 1.33 1.33 7 8 Greece* 2.65 2.65 14 16 Hungary 4.22 4.22 2.03 17 12 Iceland 6.26 6.26 21 25 Ireland* 6.47 6.47 22 26 Italy* 1.02 1.02 4 4 Latvia** 17.88 17.88 16.31 31 32 Lithuania** 13.00 13.00 11.86 28 31 Luxembourg* 5.48 5.48 19 23 Malta* 2.86 2.86 16 18 Netherlands* 1.45 1.45 8 9 Norway 8.20 8.20 25 28 Poland 2.14 2.14 1.06 12 6 Portugal* 1.14 1.14 6 7 Romania** 13.63 13.64 8.35 29 29 Slovakia* 12.73 12.74 3.03 27 19 Slovenia* 7.34 7.34 3.46 24 20 Spain* 1.71 1.71 10 11 Sweden 2.24 2.24 13 14 Switzerland 0.68 0.68 2 2 Turkey 6.22 6.22 20 24 UK 1.57 1.57 9 10 *=Euro, **=ERM 2 EU15 Variance 4.07 EU28 Variance 4.07 EU28 Post 1994 4.46 Data from Penn World Tables During the early 1990s, all of the new CEEC members (except Poland) suff ered recessions of at least 10% ( Marcours and Swinnen 2000 ) Some of these

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21 countries took 10 years to recover to their pre transition economic levels. Latvia and Lithuania are missing GDP figures from these years altogether. As a result, it seemed advisable to omit this one time shock of an economy transitioning to capitalism from the dataset for those countries, measuring only from 1994 on. The post 1994 dataset had substantially less variance by up to 73% (from 51% to 13%) in the case of Slovakia for these transitioning countries. Without these three years of da ta, the variance for the EU's numbers increases slightly (from 4.07 to 4.27 for the EU15, and from 4.07 to 4.46 for the EU28. Altogether, the results are mixed. The median country now has more volatile shocks than the median country in Karras's study (Gree ce's shocks now are 2.66 times more volatile than common ones, while Portugal's shocks were 2.11 times more volatile). But this may be influenced by a larger EU (now including CEECs) Three fourths of Karras's studied countries have less volatile shocks no w than they did before. Where before there were only two countries with less volatile country specific shocks than common shocks, now there are three, with another four hovering at parity. The CEECs are noticeably more volatile than the rest of the EU, ref lecting their status as countries still in transition. Alternatives to the OCA Model Conventional optimal currency theory provides the most common economic perspective on currency unions. When the creation of EMU made the concept of a currency union a reality, economists developed new theories as alternatives or offshoots. Endogenous OCA t heory was created to address structural changes induced by the currency union itself. Neo Chartalism, a post

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22 Keynesian critique, argues that OCA theory errs in viewing currency as a market based invention Both theories are as new as the euro itself, and a re still under development. Endogenous OCA Theory Optimal currency theory laid out clear and easily testable criteria for evaluating the suitability of a monetary union. As long as a region had high trade, labor, business cycle, and fiscal interconnectedne ss, it could create a stable single currency. But the model's simplicity did not account for feedback loops. The benefits of currency unions influence trade and business cycles, so the creation of a currency union influences its suitability ex post facto Endogenous OCA theory, developed by Jeffrey Frankel and Adam Rose, attempts to account for these feedback loops and predict how a monetary union will evolve. Trade is an important factor for a currency union as a criterion and as an effect. Following conve ntional OCA theory, a currency union will reduce transaction costs and eliminate exchange rate risk within the region. In turn, these benefits will foster more intra regional trade. Endogenous OCA theory notes that increased regional trade leads to a stron ger currency union. As such, a country that initially has poor trade linkages to other parts of a currency union might still be a good addition. Over time, the country's economy could become well connected. The increase in trade per se can change the struc ture of national economies. Frankel and Rose (1998) outlined two possibilities for structural trade: increased trade could lead to countries specializing in specific industries, or trade could stay within industries. If trade leads to specialization in dif ferent

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23 countries of a currency union, their business cycles could actually diverge, stressing a currency union and making stabilization difficult. But if most trade is intra industrial in nature (e.g. Germans buying French cars and French buying German car s), business cycles will become more closely aligned. Frankel and Rose (1998) found the latter to be the case; countries that trade more tend to have more symmetric business cycles. The addition of endogenous effects to OCA theory implies that the costs of currency union diminish over time. Conventional OCA theory discourages adding unsuitable countries to a currency union, but endogenous OCA theory suggests that economic interconnectedness is not fixed. Similarly, currency unions that appear non viable at their inception can become more stable. Even if the Eurozone was disjointed in 1998, the very existence of a currency union could help M ember S tates integrate their markets. Endogenous OCA theory addresses the stabilizing effects of currency union. However the theory is still incomplete. It is not known, for example, how to predict duration or size of these endogenous responses. Willet, Permpoon, and Wihlborg (2010) call for "more theoretical analysis of the expected time horizons for different types of en dogenous effects" and note that no work has "directly addressed how long these trade effects take to occur Additionally, it is important that the effects are strong enough to make an impact. The same authors point to Argentina's failure to increase labor flexibility enough to avert crisis in 2002. But at the same time, it is unclear how to predict the size of a trade effect or how large of an effect is necessary.

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24 In the fourteen years since the creation of endogenous OCA theory, the euro transitioned from a project to an actively used European currency. But the increases in trade expected by OCA theory have not emerged. As previously mentioned, intra EU trade has remained constant over the first ten years of the Euro. The surge in trade actually occurred i n the late 1990s, when trade nearly doubled. Since the EU instituted the Single Market in 1993, but only inaugurated the euro in 1999, the effects of the former could have completely masked the latter. Willet, Permpoon, and Whilborg (2010) found that the c orrelation of economic shocks increased equally between members of the Eurozone and non members. Endogenous OCA theory goes beyond conventional optimal currency theory by addressing feedback effects within a currency union. The ability to account for endog enous responses is important for understand ing a system like the euro, which is constantly evolving and integrating. However, the theory is still young and requires more development. A key problem is the lack of empirical examples, as the Euro is the only real example of a single currency across different states. It is likely that with more time and data, endogenous OCA theory will become more robust and powerful. But in an era where it is uncertain whether the euro has even been successful as an economic p roject, it follows that the theory surrounding it is similarly uncertain. Neo Chartalism Post Keynesians view OCA theory as invalid altogether. This disagreement stems from a fundamental difference in monetary theory. OCA theory is based in a "Mengerian" o rthodox view of money, where money is primarily a method of

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25 reducing transaction costs. Post Keynesians believe in "neo chartalism", where money primarily reflects state capacity. Accordingly, a divorce between national borders and monetary borders is absu rd money cannot exist without political institutions. OCA theory neglects state control, and chartalists view currency unions without sovereignty as projects doomed to fail. Chartalism was first proposed by Georg Friedrich Knapp in the early 20th century, and popularized by Keynes in his 1930 Treatise on Money Chartalists view money as a creation of the state. In the neo chartalist view, a state creates a currency by levying taxes payable in its own money, reinforces it by issuing payments in its currency and ensures its stabili ty by maintaining law and order (Wray 2000) Rather than emphasizing formal theory, neo chartalism focuses on "institutional detail and historical empiricism." (Goodhart 1998) The transition from barter to currency has only been made under the aegis of strong states that could guarantee the quality of currency; as these regimes collapsed the regions could split into smaller currencies ( e.g. the Soviet Union) or revert to barter (e.g. Europe's Dark Age ). It follows that there is a strong link between c urrencies and national borders currency unions or states with multiple currencies are the exception, rather than the rule. In any case, Goodhart argues that there were overriding political circumstances that created these arrangements, rather than economic efficiency. Under neo chartalism, the euro's p roblems are the result of what Goodhart (1998) calls "an unprecedented divorce between the main monetary and fiscal authorities." The euro is modeled on optimal currency theory, but Goodhart argues that the very idea is absurd if the Eurozone was an optim al

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26 currency area, an analogue of the euro should have emerged, regardless of institutional changes. Instead, the Maastricht treaty brought substantial institutional reforms at the same time as EMU. Following the neo chartalist argument, the Stability and G rowth Pact is an inadequate substitute for fiscal authority, and the European Central Bank is not democratically accountable enough to credibly intervene in the European economy. Of course, neo chartalism has problems addressing the euro. Since neo chartal ism is a descriptive theory, the fact that currencies have almost always aligned with national borders does not mean that they will continue to do so in the future. In the case of China, multiple currencies exist within national borders: the renminbi (or y uan), the Hong Kong dollar, and Macau's pataca are all official currencies within different areas in China. Admittedly, Hong Kong and Macau possess considerable political autonomy as well, but they still remain parts of the Chinese state. And in the case o f Europe, the euro is completely unprecedented. P revious "currency unions" like the 19th century Latin and Scandinavian Monetary Union were agreements to cross honor currencies, not a single currency in itself. The distinction between the orthodox and neo chartalist approach need not be in absolute terms. Even if money is overwhelmingly a product of the state, Helleiner (2003) argues that many monetary reforms have been instituted to reduce transaction costs. Neo Chartalism distinguishes itself from "metall ism", the view that money is based on its metallic backing. An increasingly popular idea blurs this distinction; money might derive its valu e from its ability to pay debts (Mehrling 2003)

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27 Finally, a purely economic explanation for the euro is incomplete. The project had as much of a political rationale as an economic one. The euro has utility as a political symbol and has benefits for the administration of the European Union. Helleiner (2003) notes that the administration of the EU's agriculture programs ( a significant portion of the budget) is made difficult with multiple national currencies, constantly fluctuating against each other. Neo Chartalism offers a unique perspective on the Euro crisis. Through this lens, the euro's problems are largely caused by a lack of political backing. A currency cannot survive without state support, so creating a single currency without a singular Europe is foolhardy. But neo chartalism has its weaknesses. This heterodox theory looks backward, instead of forward. Despite th e Euro Crisis, the euro appears to be a vibrant currency. European integration is an entirely new concept, neither an alliance of nations nor a single state itself, so it follows that a theory based in history might have trouble addressing the unprecedente d. Conclusion At the time of the Euro's formation, many economists did not find economic support for the euro The theoretical backing for an international currency was based on Mundell's idea of optimal currency areas, but the Eurozone did not meet this s tandard at its inception Arguably, it still does not. The consequences are evident today, with a crisis leaving nations on the periphery vulnerable to sovereign debt crises. But the Euro was never a purely economic effort. For supporters of the Euro, an e conomically un sound currency union simply meant that there were economic costs to their political effort. These

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28 supporters argued that the economic factors would eventually solidify under the Euro and that political action was needed first before the numbe rs would look positive Despite the political impact, the economic underpinnings are still poor and need to improve if the Euro has any chance of survival in the long run. Labor is still quite inflexible and entrenched in Europe, trade flows have not mea surably improved, and fiscal transfers are virtually nonexistent. When economies experience shocks, it is not likely that other European countries will as well, forcing the central bank to choose between price stability and saving its more hapless members from default. In the case of Greece, this meant that while it enjoyed an inflation rate of less than one percent, it has been at the brink of default for almost two years, eventually resorting to a voluntary "haircut" in order to avoid the stigma of a defa ult. The existing system is unsustainable, and the only desirable path forward is with more economic integration.

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29 Chapter 2 Political Discord The 1991 Maastricht Treaty, formally titled the "Treaty on European Union", officially coined the term European Union and laid out a framework for the implementation of a new European Union wide currency, the euro. The euro's economic roots were in Robert Mundell's Optimal Currency Area theory, but it took on a political role as well. Much as the Deutschmark had become a symbol of German national pride, the euro was to become a symbol of the success of the 40 year old European project. The stringent budget criteria of the Maastricht Treaty were only met thanks to the M ember S tates' political resolve in the face of pessimism and a bad history of European monetary projects. When the deadline for euro membership neared, all of the euro candidate states defied e ven the European Commission's expectations and adopted the euro on schedule (with the exception of Greece). A diverse group of European states united in support of the common currency, with full adherence to the guidelines that governed its use. But the po litical unity and institutional power were not permanent. By 2003, the successor to the Maastricht criteria, the "Stability and Growth Pact" failed a major test of strength. The failure to couple an integrated banking system with Europe wide banking regula tion led to massive real estate and construction

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30 bubbles in Ireland and Spain, followed by national banking crises. And as the E uro C risis became widespread, attitudes towards the EU soured and opinions on the proper response divided. The EU needs strong er financial institutions and unified action, just as political support seems to be withering away. A lack of strong policy The European Union represents a unique hybrid of sovereign state and international organization. This "supranational" organization can function as a single entity in ways that conventional international organizations cannot, especially in the realm of currency and trade. Other states now negotiate on trade with the EU and seek access to the Single Market. But at the same time, the EU is still composed of sovereign states. Outside of the areas specified in its numerous treaties, Member State s c an make their own choices. The EU treaties, though, must be ratified by each of the Member State s, making change difficult in a political and practi cal sense. Accordingly, one source of the euro's problems is the limited scope of EU power. This manifests itself in a few ways: a ) a disunit ed voice on monetary matters ; b) an inability to credibly enforce the euro's guidelines ; and c) a lack of EU wide b anking regulation. The euro faces the challenge of being an unprecedented European project in a rigid political environment. While economists and policy makers attempted to give the European Union the tools it needed to ensure a well functioning currency, unexpected complications invariably arose. In the euro's first decade, a number of crises emerged which show the inadequacy of the existing system to fully regulate the euro.

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31 Exchange Rates The euro's first stumbling block came a few months after its official inauguration. Almost immediately, the euro started losing value relative to other currencies. While a decrease in real exchange rates would normally be a positive thing, the substantial and continuous decline of an unprecedented currency unit unsettled markets and European authorities. Figure 2 1 : Value of Euro in US Dollars, 1999 2004 Source: FRED The euro's value fell from $1.18 on January 4, 1999 (the first day of trading) to an all time low of 82.7¢ on October 25 26, 2000 and did not see any significant appreciation until 2003 (FRED). European authorities failed to act in a coherent manner, which further eroded market confidence. From March to June, different organizational bodies and even different officials within the same body gave wildly different signals. EU bodies, ECB officials, and national central

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32 bankers all gave contradictory statements acted confusingly, and disagreed on even the most basic question whether the slide was a concern. This fracas left markets doubting the abilities of European authorities to properly manage the e uro. On March 11, 1999, an ECB executive board member dismi ssed concerns that the euro's slide was an issue. But three weeks later, the ECB cut its interest rate by a half of a percent in order to stimulate growth and raise the value of the euro. On April 19, the ECB president Wim Duisenberg stated that he was fol lowing a policy of "benign neglect" on the euro's exchange rate. Two weeks later, the Bundesbank's (Germany's central bank) president gave a speech criticizing this position and warning against an inappropriate "policy of neglect When the euro slid furth er in response to the EU's Economic and Financial Affairs Council (ECOFIN) easing Italy's budget restrictions, the European Council (at its June 3 meeting in Germany) attempted to downplay the changes in the euro's value. The same day, the Bundesbanker rei terated the dangers of inaction with rega rds to the euro's exchange rate (Babarinde 2003, 305) The euro's multiple roles led to a project with too many managers. Between the ECB, the different bodies of the EU, and national bankers and leaders, it was dif ficult to tell who was in charge of the e uro's policy. This confusion originated from ambiguity in the Maastricht treaty. Under article 109 of the treaty, the European Council "may formulate general orientations for exchange rate policy" with "a recommenda tion from the [European] Commission... or the ECB But apart from this provision it was uncertain how specific the recommendations of the Council could be and how

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33 much discretion the ECB had in executing its policy directions. The treaty was specific in the Central Bank's singular mandate for price stability and gave the ECB primary discretion in pursuing that goal, but it was unclear de jure whether the political or monetary authorities had more power in exchange rate policy. In order to resolve this am biguity, officials in the EU met in Turku, Finland in 1999 and Luxembourg in 2000. They agreed to make the "Eurosystem" (composed of the ECB and the Member State s' central banks) the key decider for intervention strategy. Officials formally agreed to consu lt each other before making public statements. For the most part, this stopped the chaos and confusion emanating from Brussels and Frankfurt and resolved the question of power (Henning 2007) But this solution was incomplete. The agreement gave the Eurosys tem supremacy, but did not address the conflict of statements made between members of the system. It strengthened the ECB's discretion, but did not give the Bank formal power. The debate on the "accountability" of the Central Bank to external interests sha ped the formation of the ECB. Germany's Bundesbank reflected an incredibly inflation averse nation, and was given the singular policy target of price stability. This mandate can be contrasted to the United States' Federal Reserve Bank, which has a dual man date of price stability and employment stability. The creation of a single currency concerned Germany greatly, and to prevent this inflati on bias' the ECB was given the same singular target. Similarly, concerning exchange rate policies, the debate pits t hose fearing the short term interests of the public pushing exchange rates away from equilibrium against those fearing that a central bank unresponsive to private sector interests

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34 will be delegitimized. Henning (2008) argues that central bank accountabilit y is useful when exchange rate policy diverges from "the preferences of a broad coalition of interests ." T he US was able to act against China's currency manipulation more effectively than the EU, thanks to the ability of Congress to bridge the gap between interests in a way that the European Commission and Parliament cannot. Without the ability for private sector interests to influence exchange rate policy, they will instead lobby for more distortionary measures, such as changing the trade policies of Membe r States and antidumping duties (Henning 2007) The difference between the EU and the US can be reduced to a structural one, found in each body's respective founding documents. In the US Constitution, Congress is expressly given the power "to coin Money, r egulate the Value thereof, and of foreign Coin (US Constitution Article 1 Section 8), while the Federal Reserve is not even mentioned. But in the Maastricht Treaty, the ECB is expressly named and given monetary authority over the European Commission or Pa rliament in order to pursue the goal of price stability. The merits of a more accountable or independent central bank are outside the scope of this thesis. But what this discussion reveals is a crucial issue with the structuring of the ECB. Germany insiste d on the explicit declaration of the ECB's existence, mandate, and authority within the Maastricht treaty. The consequence of this is that the ECB's character itself is as set in stone as the European Parliament, Commission, and Council. Any change to the authority of the ECB will require that a new treaty be ratified by each Member State via referendum or parliamentary approval. This is far more inflexible than the US or Germany. In the US, the existence of the Federal Reserve is only statutory and a subsidiary of

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35 the powers given to Congress. Even with Germany's Bundesbank, the model for the ECB, the "Basic Law" originally only provided for the presence of a central bank. The policy mandate and authority were statutory. The European response to the eu ro's early slide exposed two structural flaws within the EU: the inability for policy makers to account for unexpected problems, and the inflexibility of the current system to adjust quickly to change. The adjustments and agreements reached in the midst of the exchange rate slide helped to stop the immediate problem, even though the debate on the independence of the ECB continues. In any case, the ECB continues to enjoy immense legitimacy, even in the throes of the Euro Crisis. But this debate on whether th e euro's governance should be more economically optimal or politically expedient rages on in different areas. Treaties as well as banks govern the euro, and the credibility of these agreements has been damaged in multiple crises. Credibility and the SGP Th e most important of these agreements were the Maastricht Convergence Criteria. The Maastricht criteria included caps on inflation levels, interest levels, debt levels, and deficit levels. Although it did not look like many countries would be in compliance as late as of 1997, by 1998 almost every candidate country got their finances in order and was recommended for adoption (Greece, the exception, joined two years later). In the fourteen years since the Euro's adoption, the fiscal cr iteria have remained the same: a debt to GDP ratio of 60%, and a deficit to GDP ratio of 3%. Meanwhile, the enforcement behind the requirement changed twice, in 2005 and 2012. These changes were made in

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36 response to Member State s attempting to shirk their obligations and run larger deficits than allowed. The original Stability and Growth Pact contained provisions to enforce the fiscal criteria. It was designed to prevent a free rider problem where Member States might decide to run larger deficits than otherwise. In a currency union, states suffer less of an inflationary impact from running a budget deficit because the consequences are averaged out among the entire monetary union. Since every state has this incentive, inflation will be higher than normal without some sort of control. I nflation averse Germany insisted on a sanction mechanism as a condition of joining the EMU which came in the form of the SGP's Ex cessive Deficit Procedure (EDP) (Leblond 2006) If a nation ran a deficit higher than 3% of GDP, the European Commission woul d issue a warning, which would be approved by ECOFIN and sent to the European Council for sanctions. This system seemed like a strong plan in theory but in execution delinquent states could block the process at several points. The Commission could decide to be lenient in its proceedings, and a Member State 's representatives to ECOFIN 4 could block the proposal wi th support from other countries (Schuknecht et al. 2011) The latter turned out to be the downfall of the EDP in the 2003 Stability and Growth Pact crisis. In 2001, Portugal ran a 4.2% budget deficit. Rather than taking action, the response from the EU was confused. The European Commission recommended issuing a formal warning in January 2002, but ECOFIN did not endorse it, and 4 ECOFIN (short for Council of Economic and Finance Ministers) is comprised of Member States' economic and finance ministers

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37 argued "there was not y et cause for concern even if the government's budget deficit was rising rapidly above its target level (Leblond 2006 ; 971 ) ECOFIN decided to act in November, but within a few months decided to pull back. The fiscally conservative government elected that summer started reducing budget deficits on its own accord, and ECOFIN decided that action was not necessary. But in 2002, Germany and France started exceeding the deficit threshold by similar amounts. Germany's failure to follow the guidelines it insisted on provoked criticism within Europe. The European Commission recommended that ECOFIN give formal notice to the two countries for running excessive deficits and asked France and Ger many to reduce their cyclically adjusted deficits by 0.6 and 0.8 percent of GDP respectively. Germany argued that all of its deficit was due economic stagnation, and instead planned to cut !22 billion of taxes (Leblond 2006) ECOFIN, however, did not follow the Commission's recommendation. In November of 2003, Portugal and Italy's representatives to ECOFIN supported Germany's and France's in blocking a vote to formally warn the two countries. The action was shelved indefinitely. The SGP crisis was this failure to act on France and Germany's deficits and actually enforce the provisi ons. The Excessive Deficit Procedure failed its first test. Through ECOFIN, any Member State could effectively scuttle punitive action for running deficits. The deterrent mechanism lost all credibility. In response to the crisis, the 2005 SGP reform attemp ted to become more lenient with the criteria, by introducing a longer time frame to act than the two months originally al lowed and relaxing the 3% limit (Schuknecht et al. 2011) This may have been

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38 an attempt to encourage Member States to comply by making it easier to do so, but the absence of enforcement left the agreement open to be violated by more powerful countries. In this sense, the European Union faces a problem endemic to international organizations. While the Union exercises control over the Singl e Market, over other issues the Member States still have complete or partial sovereignty. Germany's interes t in the SGP was self serving: i t wanted to be able to subject "peripheral" states to control, without being bound to the fi scal constraints itself. Leblond (200 6 ) considers how the SGP crisis could be viewed if it was merely meant to be a carrot for Germany to accept the EMU. In this case, European Authorities would have designed the EDP never intending it to be credible in the first place, expecting the entire procedure to become irrelevant after euro adoption. If this were not the case, Lebl ond argues, then policy makers would have instituted automatic sanctioning procedures. And the fact that long term bond yields barely moved during the entire cris is shows that investors never expected the restrictions to be credible. EU Banking System, National Regulation Even then, non credible restrictions are better than a lack of regulation. While Germany insisted on limits of public debt in order to agree to t he euro's formation, no country asked for limits on private debt because of their commitment to the European Single M arket. The European Union created a situation where public debt was highly regulated but private debt was not. Ultimately, the failure to t ransfer significant political power to the European Union along with the significant transfer of financial power led to the EU's

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39 inability to regulate banking on a European scale. This imbalance led banks to overleverage their loans and created consumption bubbles in several European countries. One of the original members of the ECB's Executive Board, Otmar Issing characterized the euro as "a currency without a state (2008). Many scholars writing after the start of the Euro C risis characterize d this as a mistake or an oversight on t he part of European authorities (Sapir 201 2, D’ez Medrano 2010, Caporaso and Kim 2012) But at the time of the formation some policymakers saw the Euro as an unprecedented opportunity: to play a "pacemaker role" and t o lead political union. The French policy maker Jacques Rueff declared in 1950 that L'Europe se fera par la monnaie ou ne se fera pas ("Europe will be created through the common currency or it will not be created at all) (Quoted in Issing, 2008). Before the Maastricht treaty, European institutions had a much more narrow scope. Even the Single Market was created in 1992. Accordingly, policy makers might have figured that the political changes (which experts now believe are necessary) were too large to swal low on their own. Following this reasoning, it makes sense that the EU did not create a system of fiscal transfers or a unified banking regime. Even though many present day experts argue that these things are necessary for the stability of the euro, asking the Member State s to start contributing substantial portions of their GDP or to delegate something as important as banking regulation to a still evolving international organization may have been considered unthinkable. Additionally, European authorities were putting the final touches on the Single Market. The EU defines its Single Market in terms of four freedoms of

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40 movement: "the free movement of people, goods, services, and capital" (Eurostat) By 1992, the European Union fully liberalized European capi tal markets and allowed any European financial institution t o provide cross border services (Sapir 2011) Authorities may have been hesitant to control capital flows, so as to not detract from one of the Single Market's Freedoms. The philosophical decision to form the Euro without a correspondingly powerful political union led to practical consequences in governing the Eurozone Most notably, the EU decided to leave the regulation of banks to national authorities, regardless of their abilities to lend acros s borders. The previous chapter addressed the existence of a monetary trilemma' in which states must choose to sacrifice free capital flows, stable exchange rates, or an independent monetary policy in order to successfully pursue the other two goals. Sap ir (2012) observes a parallel to this in the European Union: t he "Financial Trilemma ," where a monetary union must give up either free capital flows, financial stability, or national financial regulation. Following this theory, the choice of the EU to libe ralize cross border lending while leaving individual Member State s to regulate "their" banks forced an inevitable financial crisis. Whether or not it is necessary to frame this argument as a trilemma (as it is unlikely that any union would willingly opt fo r financial instability) is irrelevant, as the message is clear: failing to regulate the banking sector on the same scale as the monetary union itself is dangerous. Unfortunately, the decision to postpone financial regulation left Europe extremely vulnerab le in the event of a crisis. The T reaty of Maastricht expressly prohibited "all restrictions on the movement of capital between Member States

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41 and between Member States and third countries" (Article 73b TEC, II.G.15 Treaty of Maastricht), a restriction that lives on even in the current treaty. It was not until the 2007 Treaty of Lisbon that the EU had a "shared competence" in economic regulation (including banking regulation). The treaty of Maastricht gave Member States the competency of financial regulation (as an economic policy), merely directing Member States to "act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources..." (Article 102a TEC) and to "regard their economic policies as a matter of common concern and coordinate them within the Council" (Article 103.1) The product of this statutory discouragement of European banking regulation was a lack of Europe wide bank rescue coordination procedures (Sapir 2012) The European ba nking authority, which now oversees bank rescue and restructuring, was not established until 2011. Its predecessor, the Committee of European Banking Supervisors, was merely created to enforce EU directives and provide for information sharing. The final re sult of this lack of regulation and supervision was an epidemic of consumption bubbles in Ireland and Spain. The opening of capital markets was supposed to promote a flow of financing from capital rich northern Europe to the South and East and promote busi ness investment. With access to these capi tal markets, industries in the periphery' could invest in expansion and new technology and c atch up to the more prosperous core' in what was cal led convergence' Unfortunately, the industries of Southern Europe did not catch up to Germany's, where labor productivity skyrocketed and exports surged. Instead, the influx of cheap cre dit went to finance consumption (Eichengreen 2011) Spain

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42 and Ireland experienced booms in hou sing, tourism, and construction (Caporaso and Kim 2012) Banks in these countries were now able to borrow cheaply on the European interbank market in order to supplement their local deposits. By 2007, Eurozone bank debt shot to 250% of EU GDP (De Grauwe 2011) When the 2008 financial crisis hit Eu rope, credit markets dried up and the overleveraged banks were stuck. Ireland and Spain rescued their banks at a considerable cost to their public debt Ireland's budget deficit for 2010 was 32% of GDP, more than ten times the number allowed under the SGP. A lack of political unity Many of the euro's political problems were in the institutions of the European Union. A lack of credibility and authority meant the EU could not solve problems outside of its narrowly defined scope. But an equally troubling proble m in resolving the crisis is the increasingly polarized, unfriendly, and disunited political environment. Some of this erosion in support has been due to long standing trends; as the grand European project increased in scope it turned from an agreement of elites to a high profile debate among a more diverse public. Some of it is because of the economic climate, and people are only looking for an "other" to blame until things get better. And some of it is intentional, caused by a fundamental disagreement on how to properly save the euro. In any case, the toxic political environment is dangerous to the euro. Political commitment pulled the euro together despite a shaky economic backing, and the euro cannot survive for long without a unified Europe backing it.

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43 The Problems of Engagement Twenty five years ago, the idea of a "European Union" was distant to most people. Many experts viewed the debate on European integration as a battle between elites. The public was considered to view integration as a political "no n issue", where issues of integration would not affect them. European Parliamentary elections were considered "popularity tests for national governments ," and the public's opinions on integration were assumed to be su perficial (Hooghe and Marks 2009 ; 6 ) T he Maastricht treaty symbolized the transformation of the debate from one between elites to a high profile issue. With the creation of the European Union a name to symbolize these transnational integration efforts, and the euro a very visible consequence of integration efforts, voters became more Europe minded. As the public started to pay more attention, the progress of integration slowed down from what Hooghe and Marks (2009) called permissive consensus to constraining dissensus By the early 2000s, vo ters considered European Integration to be one of the most important issues to them, especially for Eastern European countries still in the process of joining. Elites now had to consider public opinion in debates, and thus int egration changed from a quickl y moving process negotiated by a small set of elites to a much more deliberate process actively engaging the public. Of course, the public started paying more attention to integration because integration efforts themselves started to become bigger. Before Maastricht's introduction, European integration was much less salient. The European Community (the EU's predecessor) had a much smaller scope, focusing on the

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44 creation of the single market. Although the EC made some important achievements, including the c reation of a customs union and the dismantling of tariff barriers, these market reforms were largely invisible to the average person. People had no reason to care about a European political union when the "implications for most people (except perhaps for f armers) were limited or not transparent." (Hooghe and Marks 2009) Maastricht made the European Union evolve into what it is now; a "part of a system of multi level governance which facilitates social interaction across national boundaries, increases immigr ation and undermines national sovereignty." At the same time, the EU has not only "deepened" integration by dealing with more issues on a European scale, but it has also "broadened" integration by expanding further eastward. This culminated in the 2004 ac cession of ten Central and Eastern European Countries (CEECs), the 2007 accession of Romania and Bulgaria, and the 2013 accession of Croatia (scheduled to take place on July 1). The introduction of countries on the other side of the Iron Curtain makes inte gration more difficult. Now, not only are there more actors in EU negotiations, but these new countries force Western Europeans to adopt a more inclusive definition of "European" identity. While the EU has undergone profound economic and political integra tion, Europeans do not see themselves as an increasingly integrated people. The "Eurobarometer" survey, commissioned by the European Commission to gauge public opinion on integration, has asked whether respondents see themselves as citizens of their respec tive countries, citizens of Europe, or both. Over the twenty years of this question being asked, responses have largely stayed the same. A

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45 similar number of people consider themselves only national citizens as both national and European citizens. Figure 2 2 : National Identity in the EU, 1992 2010 Source: Eurobarometer If identities have remained largely unchanged over the past twenty years, it follows that Europeans will be hesitant to cede more domestic po wer to the EU. D’ez Medrano (2012) believes that this is the case, stressing "the widespread lack of support for further transfers of sovereignty among European Union member states" as a problem in "solving" the Euro Crisis. He observes an "increasing numb er of crises because a great deal of integration has already taken place and neither the population nor the states' leaders support a fully supranational European Union." Similarly, Hooghe and Marks (2009) argue that there is

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46 limited room for additional ec onomic redistribution, since "Citizens are loath to redistribute income to individuals who are not perceived to belong to the same community." Short Term Procyclical Support Just as European politics is turning from small negotiations to massive public bat tles, making progress harder, the political situation is rapidly turning unfavorable. This is because the crisis itself has eroded support from the EU and euro. As the financial crisis hit Europe and started threatening banks and economies, people started feeling the effects individually. They started seeing a united Europe as a liability, not an asset. The benefits of a single market stopped being outweighed by the pain of economic shocks being transmitted across borders. D’ez Medrano (2012) empirically me asured this effect, finding a correlation (r=0.43) between net support of the EU and 2 year lagged 3 year average GDP growth (see Figure 2.3) In order to operate in a more hostile environment, even pro Europe factions have had to backtrack or take a backseat. Duff (2012) laments, "the old certainty of nding a broad majority for more Europe' has gone", observing that "various strands of marked Euroskepticism are to be found across the present [European Parliament]". In German Chancellor Angela Merkel 's first term of office (2005 9), she was instrumental in saving the Lisbon treaty and promoted Europe as a community of common values. In her second term, she retreated to nationalism and stressed the importance of national interest in European co mmitment s (Schmidt 2012) The remaining champions of an integrated Europe are the European Commission, Parliament, and Council (Duff 2012)

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47 Figure 2 3 : EU Net Support vs. Real GDP Growth, 1998 2009 Reproduced from D’ez Medrano, Juan. "The limits of European integration." Journal of European Integration 34, no. 2 (2012): 199. With the erosion of public support and the flight of pro European forces, the public was left without a voice in support of Europe. Caporaso and Kim (2012 ; 786 ), when talking about the consequences of a euro breakup, voice concern that "[it] is not clear to what extent the German public understands the multiple sources of the advantages brought to them by the euro." Similarly, Duff (2012 ; 141 ) notes EU citizenship remains a largely unknown quantity, and its benefits uncertain." Assuming the economy of Europe recovers, public opinion may return in favor of a united Europe. But the coupling of a slower moving process with bad political attitudes in a crisis that requires quick and drastic reform makes the short term situation look dangerous.

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48 Conclusion Fourteen years after the official introduction of the euro, and eleven years after the beginning of circulation, the euro remains a common European currency. The creation of a common currency remains the most visible achievement of European Integration. In the 1990s, Member State s united around the euro as a symbol of unity, and even in the deepest recesses of crisis, troubled states like Greece, Spain, and Ireland are willing to undergo harsh austerity measures in order to stay a part of the project. But this political power behi nd the euro is showing cracks. It is difficult within the system to change political structures, as the treaties making up the EU are specific, and altering them in a major way requires the unanimous consent of Member State s. Since the crisis began, there have been some positive structural changes. The Lisbon treaty, which came into effect in 2009, gave more power to the EU and empowered the European Parliament. While this reform may make progress move slower than under the more elite Commission, it gives t he EU more legitimacy in the eyes of a public that is watching closer than ever. The SGP h as been replaced by a stronger Six Pack' which makes the sanctioning process easier and has new provisions for economic and financial monitoring. The European Banki ng Authority's creation has, for the first time, provided for a system of European bank stress tests and is tasked with the coordination of bank restructuring and rescue efforts. Still, these efforts are not enough. Many experts agree that further restrict ions or integration are required in order to solve the crisis and keep the euro stable for the foreseeable future.

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49 Chapter 3 Solutions The Euro Crisis exposed many structural flaws in the euro itself and the EU. The euro attempted to unite disjointed regions unde r a single currency, which resulted in an area able to transmit shocks, but not to remediate them. The EU proved too inflexible to meet the needs of an evolving euro. Europe simultaneously suffered from immobile labor and uncontrolled capital flows, and wa s unable to switch to a transnational framework to regulate a transnational banking sector. And now, in the throes of crisis, the entire political situation has become unfavorable just when reform is needed. Some commentators see a Eurozone breakup as a po ssibility, but European officials are working towards the opposite. The best way forward is to reform European institutions in three ways: by creating a banking union, a fiscal union, and a political union. Rather than disbanding the euro, a messy process that will damage Europe economically and politically, it is necessary to reinforce it. Breakup With the picture in Greece becoming clearer, and with the escalating crises of other peripheral' states in the Eurozone, the question has been raised: Why not d issolve the union? The status quo is proving costly for countries forced to

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50 accept harsh austerity packages in exchange for bailout funds. Citizens of richer Member State s are growing tired of bailing out countries seen as fiscally irresponsible But a b reakup of the euro has massive costs in a political and economic sense. The framework of the euro and of EMU does not provide for a country's exit. This was done in order to prevent a country from leaving without either undergoing a protracted negotiation process or burning bridges with the EU. Similarly, European officials have not even acknowledged breakup in fear of legitimizing it as an option for Member State s. The legal consequence of this is that any attempt to introduce an exit framework would requi re the unanimous approval of Member State s, triggering plebiscites in many countries in a multi year process. Any attempt to unilaterally secede would force the Member State to leave the EU entirely, due to the substantial violati ons of all of the EU's tre aties (Deo et al. 2011) The entire structure of the EU is built to keep members working within the system, and exit is intentionally unattractive to a country. In addition to the legal consequences, a country exiting the euro will face substantial economi c damage. Deo et al. (2011) estimated the costs of a weak country leaving the euro at 40 50% of GDP, and of a strong one leaving at 20 25%. For a weak country, this manifests in sovereign debt default and capital flight. For a strong country, the costs com e from an appreciation in currency. Both will suffer from the collapse of their banking sectors and the breakdown of trade with the EU. A weak country leaving the Euro will be forced to make devastating sacrifices. Given a massive depreciation in local cur rency, the country will have to either force the conversion of its sovereign debt (which will be seen as

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51 a default by investors) or see its debt burden balloon in terms of its currency. In order to prevent bank runs, the country will have to either institu te harsh capital controls or close banks. As its currency depreciates, the EU will likely compensate by levying high tariffs to c ounteract currency depreciation (Deo et al. 2011) Even then, the country will probably not be able to save much of its banking system. Bank runs are likely to occur as soon as a breakup is seriously considered (Belke and Verheyen 2013) A strong country will face an immediate appreciation of its currency relative to the euro (Deo et al. 2011) This means that its industry will be less competitive than the rest of Europe's, and any export related industry will collapse. Additionally, many banks in the country will take a hit to their balance sheet. Their deposits will be revalued into the appreciating local currency, while any inte rnational assets will remain in euros. They wi ll need to recapitalize (Belke and Verheyen 2013), leading to a short term credit crunch. The exiting country also faces the likelihood of political upheaval. With the weak country's banking sector devastated, savings and pension plans will be destroyed. With the strong country's export industry contracting, many thousands of people will be out of work. Deo et al. (2011) looked at historical examples of countries exiting monetary unions. All of these countries ( the US leaving the gold standard in 1933, the Soviet Union breaking up in 1991, and the Czech Republic and Slovakia divorcing in 1993) either faced civil war or became more authoritarian. Even in the US, state militias were called in to quell public dissen t in the middle of a banking holiday. In a breakup, the EU would be severely wounded. A single country leaving would likely lead to more following.

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52 The destruction of the euro would represent the failure of one of the primary goals of the European Union, w hich would lose most of its international legitimacy. Fortunately, the costs of disunion are high enough that breakup remains only a remote option. Greeks and Germans alike are ultimately still committed enough to the existing system that they do not consi der breakup a viable option. That being said, it has become clear that the status quo is unsustainable, and if the Eurozone is not going to break up it must become more powerful and able to respond to shocks. Banking Union The 2008 global financial crisis played a major role in triggering the Euro Crisis. As stated in Chapter 2, the lack of Europe wide banking regulation led to Member States like Ireland and Spain being overwhelmed with financial collapse. Banks were able to borrow money from across Europe, but were regulated on the national level. When a wave of bank failures hit Ireland, the government was not able to handle the implosion of its banking sector and took on its GDP in sovereign debt. National financial policy does not make sense in a suprana tional currency regime with increasingly integrated banks. In order to prevent another banking crisis, the European Union has taken steps to create a stronger banking regime. In 2011, the EU formed the European Banking Authority, designed to oversee nation al banking regulators and coordinate financial policy. But this agency could not dictate regulation of its own and was still subordinate to national regulators. The European Commission issued a proposal in June of 2012, which was adopted by the European Co uncil in

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53 December. The European Parliament passed portions of the proposal into law in March of 2013, but as of mid April banking union remained incomplete. Under the current system, Member States are responsible for regulating their own banks, supervising them, setting up deposit insurance schemes, and resolving bank failures. The Commission's proposal unifies national banking regimes with four reforms: First, a Single Rulebook will govern banks. Second, a Single Supervisory Mechanism (SSM) will be respons ible for overseeing them. Third, a common deposit protection will either supplant or support national deposit insurance. And fourth, a Single Bank Resolution Mechanism will oversee bank restructuring and liquidation. Pisani Ferry et al. (2012) outlined sev en questions to consider when designing a banking union: 1) Which countries to include; 2) Which banks to include; 3) Which institutions to supervise the project; 4) How to assign resolution authority; 5) How centralized of a deposit insurance system; 6) H ow to fiscally back the project; 7) What governance framework. An additional question is in time scale and priority, since some reforms may be quicker or more politically expedient to undertake. The proposed banking union will encompass the Eurozone, with an option for other Member States to join (European Commission 2012) This represents a middle ground between a union the size of the Eurozone, and one the size of the Single Market. This flexibility is practical, since it allows in newer states already ex pected to adopt the Euro, while allowing for countries like the UK to opt out. There are technical problems in not having an absolute solution, such as the

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54 uncertain role of the European Central Bank in a non euro country, but the practical benefits outwei gh these concerns. Figure 3 1 : Responsibilities of the Single Supervisory Mechanism Reproduced from Verhelst, Stijn. 2013. "The Single Supervisory Mechanism: A Sound First Step in Europe's Banking Union?": Egmont Institute. The banking union will cover all banks, but not completely. The SSM only covers "essential tasks" of banks, and indirectly supervises "less significant banks" 5 This means that the SSM directly covers 150 out of the 6,000 banks in the Eurozone, accounti ng for 80% of total bank assets (Verhelst 2013) This is in line with the recommendations of Pisani Ferry et al. (2012), who a dvocate for broad coverage. The Single Supervisory Mechanism will be put under the European Central Bank. This is seen as a good move, since the ECB gained a large amount of credibility handling the crisis (VŽron 2012, Pisani Ferry et al. 2012) In order t o 5 A bank is considered "significant" when it meets any of the following five criteria: 1) More than 30 billion of assets; 2) More than 5 billion of assets, being more than 20% of the GDP of t he Member State in which the bank is located; 3) Is one of the three most significant banks of a Member State ; 4) Substantial cross border activity; 5) Receives assistance from a Eurozone bailout fund (Verhelst 2013).

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55 give non Eurozone countries representation, decisions are made by a new supervisory board. This board also includes ECB representatives that are separate from the Central Bank's monetary functions, in order to prevent a conflict of interest. The SSM repr esents a substantial step towards banking union. But currently it is the only step. This is because full fledged banking union needs to be supported by political and fiscal union as well (VŽron 2012, Pisani Ferry et al. 2012) VŽron (2012) believes that SS M regulation has gone "about as far in the direction of banking union as is possible at this stage." Banking reform in and of itself is not an ambitious goal, but it requires the completion of a much more substantial reform: Fiscal Union. Fiscal Union For as long as there has been discussion on a single currency for Europe, there has been discussion on the necessity of a fiscal union. A fiscal union can serve as a stabilizing mechanism for economic shocks, encourage economic cooperation, and strengthen othe r reforms. According to Optimum Currency Area theory, areas with high capital mobility are well suited for a common currency. Fiscal transfers serve as a type of capital flow, so a fiscally integrated Europe can help economically strengthen the euro. Howev er, public spending remains a national affair in Europe. The European Union's budget is tiny, and the few fiscal transfers exist to solve long term inequalities. In order to support the euro as a monetary union, the EU needs the resources that a fiscal uni on provides.

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56 The first arguments for European fiscal union (or fiscal federalism) came in response to the Maastricht Treaty. Eichengreen (1992) noted that the EU did not have the capacity for stabilization, and that there was no good way to create a fiscal federalist system in the EMU's framework. He compared the EU's emphasis on long term funds to the US's powerful fiscal mechanism, and voiced concern over the lack of a European counterpart. Since then, little has changed. Over the past twenty years, the E U's budget has remained at around 1% of GDP, with most fiscal transfers coming in the form of cohesion funds or agricultural subsidies. It still does not have capacity to stabilize, and has sought assistance from the IMF in bailing out Greece (Eichengreen 2011) Hallerberg (2011) argues that a fiscal union was not necessary while the EU and European Central Bank's pledge to not bail Member State s out of debt crises was credible. Even in the case of Ireland, the country willingly underwent austerity measures to avoid a bailout. But this was no longer the case. The bailout "[severed] the connection between the health of a country's public finances and the rating of its bonds." Even then, a no bailout pledge may have not been optimal for political reasons. In 2 009, the Greek prime minister admitted that Greece had been falsely reporting its budget information in order to adopt the euro, and without a bailout would have likely defaulted. Without bond markets holding a country accountable for its finances, the onl y alternative is a central agency overseeing finances. Modern proposals for a banking union rely on a corresponding expansion of European spending. A fiscal union will give European agencies the resources for larger rescue projects. The ECB has insisted o n not becoming a lender of last

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57 resort 6 for European banks, in contrast to the Federal Reserve, the Bank of England, and most other central banks. In the Euro Crisis, the ECB took on this role reluctant ly and faced intense criticism (Sapir 2011) While a l ender of last resort is a key part of many banking stabilization systems, the ECB justifies its reluctance by a lack of fiscal backing. With the EU's limited funds, the ECB is forced to seek external aid in banking crises. Even a limited fiscal union can h elp create a solid backing for the ECB. 7 Fiscal union can give the European Union more rescue options. Along with levying taxes, the EU can bail out troubled countries by converting their sovereign debt. Eichengreen (2011) suggested the creation of E bonds ; bonds backed by the entire EU or Eurozone. Allowing troubled countries to convert a portion of their outstanding debt to European debt will lower their cost of borrowing, keeping them away from a default. For example, Greece's current debt load is high a nd expensive. 8 In order to pay down its debt in a reasonable fashion, Greece will have to dedicate one third of its tax revenue to interest (Caporaso and Kim 2012) In a fiscal union, the EU will be able to assume much of Greece's risk and speed a return to solvency A major issue for fiscal union is the incentive for countries to "cheat" an agreement by either falsifying budget numbers or overspending (Keuschnigg 20 12) To fix this, most fiscal union proposals include supervision by European authorities or independent agencies. Suggestions range from mandating budget 6 An institution that lends money to b anks unable to borrow anywhere else in order to prevent collapse. 7 Marzinotto et al. (2012) estimates that a levy of 2% of European GDP would let a banking rescue operation borrow !2.25 trillion at 4 percent interest, "large enough to take Italy and Spain from the market for several years." 8 Current Greek 10 year bond y ields are at 11 percent.

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58 councils to ensure proper disclosure (Schuknecht et al. 2011) to creating an entirely new European fi nance ministry with veto power over national budgets (Marzinotto et al. 2011) These measures are beneficial for a country by themselves, and a fiscal union can serve as a catalyst for fiscal discipline and budget transparency. Specialized oversight is bet ter than the system of rules currently in place. The SGP, six pack, and fiscal compact all face credibility issues, and a fiscal union will put more importance on an effective mechanism. Creating a fiscal union will be a large step for the EU, and require s competencies the current Union does not have. Accordingly, the countries of Europe will have to ratify a new treaty. This is a deliberate process that would take three or four years (Marzinotto et al. 2011) It includes a European Convention to gather in terested parties, an Intergovernmental Conference to draft the treaty, and ratification by all Member State s. Critics of a fiscal union point to this slow moving procedure as its key pitfall, since a substantial delegation of authority would not be politic ally sustainable (Keuschnigg 2012) Compared to the alternatives, however, a fiscal union is a better option. Political Union A politically integrated Europe has long been the goal of European integration efforts. Founders of the euro saw it as an opportun ity to later institute politica l reform (Issing 2008) The most recent attempt at political union came in the 2005 European Constitution, abandoned after failing referenda in France and the Netherlands. Instead, the Treaty of Lisbon made much less ambitiou s reforms. In the wake of the Euro Crisis, calls for political union have resurged. It has become clear that the European Union needs substantial integration to back

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59 the euro. Proposals for a banking union rely on not only a fiscal union to provide monetar y resources, but also a political union to legitimize EU actions. Although there is wide agreement on the necessity of political union, there is no real agreement on what it entails. There is a general understanding that it includes increased competencies for the EU and requires a new treaty. Beyond this, there is a wide range of ideas. The key disagreements are on whether to include all of the EU, whether to restructure political bodies, and to what extent powers should be delegated. The recent debates on political union have popularized the concept of a "two speed Europe". Since political union emerged as a response to the Euro Crisis, proponents of a multispeed solution saw problems with the Eurozone, rather than the entire EU. Not including all 27 Membe r States makes political union more politically feasible by allowing traditionally euroskeptic countries like Britain to opt out of reform (Janning 2012) The problem with this approach is that it creates tension within the EU. The only democratic bodies e xist on the EU level, so anything smaller will either let European Parliament members from outside the group vote on political union or force political union decisions on non group members (Dullien and Torreblanca 2012) A common criticism of the EU has be en that it lacks democratic legitimacy. To address this, the Treaty of Lisbon gave the European Parliament more power over the Commission and Council. Some proposals for political reform go further, by encouraging pan European election campaigns (Duff 2011 ) calling for half of the Commission to be appointed from MEPs (Janning 2012) or redu cing the size of the Commission (Dullien and Torreblanca 2012) On the other hand, proposals

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60 like that of the European Council favor giving more power to indirectly acco untable bodies, in a similar fashion to the Single Supervisory Mechanism. The biggest debate, however, is in the size of power transfer. Since the discussion of political union revolves around economic factors, the scope of political union depends on what is deemed necessary to solve the crisis. For those that believe the Euro's problems are due to a lack of enforcement ability for agreements such as the SGP, political union will center on strengthening these agreements. Schuknecht et al. (2011), for exampl e, suggests creating automatic sanctions for excessive deficits, rather than relying on votes in the Commission. Germany's Foreign Minister Guido Westerwelle proposed giving the EU the ability to direct eco nomic policy, but not much else (Janning 2012) Bu t for those that believe that a fiscal union is necessary, political union will be much more ambitious, empowering the EU to issue bonds and raise taxes. The ultimate tension for political reform efforts is between short term political viability and long t erm adaptability. An approach that only focuses on stabilizing the euro in the short term, does not require large changes to the EU's institutions, and asks little from Member States will not face much controversy. But it is unlikely that this system will last for long before Europe faces another crisis. One of the structural failings of the EU has been its inability to adapt and respond to unanticipated problems, so a rules based regime that allows little discretion will only postpone trouble. A long term solution is needed to support a banking and fiscal union, one that gives the EU more power and al lows for more direct legitimacy.

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61 Conclusion The Euro Crisis has forced a decision on Europe: Either face a breakup of the Eurozone, or integrate further. A bre akup would be catastrophic, irreparably damaging the European Union and the economies of Europe. The only reasonable option is to strengthen the euro and strengthen the union. A European banking sector must be managed on a European scale, so the EU will ne ed a banking union to give banks one set of laws, manage them with one banking regulator, insure their deposits under one scheme, and provide one institution to stabilize crises. A fiscal problem in any Member State is a problem for all of Europe, so the E U will need a fiscal union to provide resources for bank rescue, provide debt relief for threatened countries, and manage the budgets of Member States. Finally, these reforms need to be backed by political union, in order to create a European Union that is more politically competent and more democratically accountable.

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62 Conclusion Popular explanations of the Euro Crisis place the blame on c ountries: Either the so called PIIGS' are responsible for their own demise through wasteful spending, or countries lik e Germany are overzealous in pushing austerity measures. These explanations tend to be excessively simplistic and narrow, based on nationalist rhetoric. It is more helpful to look at the Euro Crisis at a structural or institutional level, viewing the sover eign debt crises as symptoms of structural problems rather than causes in and of themselves. The first chapter evaluates the suitability of the Eurozone as an application of Optimal Currency Theory. It finds the two conditions for an Optimal Currency Area, highly symmetric economic shocks and high internal factor mobility, lacking in the Eurozone. Studies have found capital and goods to be mobile inside the Eurozone, but fiscal transfers are minimal and labor is highly immobile due to linguistic and cultura l barriers. The Eurozone as a whole does not have symmetric busine ss cycles, but there is a core' area, centered on Germany, which might. The second chapter analyzes the political structures surrounding the euro. The failure to initial exchange rate slide of the euro, the 2003 Stability and Growth Pact Crisis, and the Euro Crisis's initial banking crisis reveal political

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63 institutions that have problems with coordination, enforcement, and proper regulation. The legal framework surrounding the EU and euro is unable to adapt quickly to change. Additionally, political unity towards an integrated Europe is faltering. Political support is as vital to the Euro as economic viability, so its erosion is problematic. Elites tend to be more in favor of integration than the general public, so as European issues become more salient, progress becomes more controversial (and therefore deliberate). Support for the euro also varies with economic progress, so when a downturn occurs it becomes more difficult to enact reforms. T he third chapter proposes long term solutions to the Euro Crisis. While breakup is a possibility, it is extremely unlikely. The costs are immense and institutions are designed to discourage exit. Three major reforms are needed to ensure viability: Banking union, fiscal union, and political union. These changes seek to solve the mismatch between supranational monetary policy and domestic economic and financial policy. A European banking union will keep banking problems from turning into sovereign debt proble ms by regulating, supervising, insuring, and rescuing banks on a European level. A European fiscal union will give the EU more resources to stabilize economies and reduce structural inequalities, while supporting a banking union. Finally, political union w ill give European institutions the authority to pursue these changes and react to future problems. Recent Developments and Future Possibilities Fourteen years after its official creation, the euro is still an unprecedented project. The econometric studies referenced in the first chapter looked at Europe

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64 before the adoption of the euro. A possible study could evaluate whether the introduction of a single currency influenced business cycle symmetry. The Euro Crisis is still ongoing. While Europe's e conomy appears to be on a path of slow recovery, political developments are less predictable. The solutions outlined in Chapter 3 indicate suggested EU reforms, but future events may indicate better solutions. As of the writing of this paper, the Cypriot b anking crisis is still less than a month old. The banking crisis occurred days after the Single Supervisory Mechanism passed into law. Will the emergence of a new banking crisis encourage the Europeanization of banking regulation or discourage it? The best way to analyze the Euro Crisis would be after its resolution, as it remains to be seen how institutions actually evolve in response to the crisis.

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