Why Europe Went to the Brink

One reason for the European financial crisis was that markets did not impose the necessary discipline on the member states, in particular during the first years of monetary union, as spreads narrowed on different government bonds independently of emerging potential problems.

Markets moved in a binary way, from all good to all bad, in an abrupt and pro-cyclical way.

Another reason was that the Growth and Stability Pact did not work as expected. Surveillance proved difficult to implement, technically and politically. Sanctions gave rise to tensions between national authorities and European institutions. The latter became a scapegoat, being accused of interpreting the Pact too rigidly and rigorously. As a result, the rules were weakened and “politicized,” leading to less-stringent monitoring.

The third reason was that, in the midst of the worst crisis since World War II, the belief that countries could be left to their own devices — and eventually fail — without infecting others, proved wrong.

Several academics and commentators are still flirting with the idea that a partial default could be organized in an orderly fashion, with minor repercussions on the country itself and on its neighbors. But financial markets have shown how exposed they are to contagion — contagion which, by the way, is not limited to the euro area. It's global.

The final reason for these misplaced assumptions was that, during its first 11 years, the euro area economy experienced a strong convergence in real economic activity together with a significant divergence in nominal cost and price developments, which gave rise to large payment imbalances within the Union.

Countries with lower income per capita grew faster than the richer ones, in some cases catching up with them, partly through excessive external borrowing and a decline in competitiveness. These developments were not offset by conservative fiscal policies to moderate domestic demand growth and to provide a buffer for any shocks.

A further dimension is the difference in cultures and sensitivities. They affect how issues are communicated within countries — in particular, between politicians and their electorates. These are differences which totally disconcert financial markets.

For instance, in one large euro area country it was thought that public support for swift action could be achieved only by dramatizing the situation — for instance, by telling the public that "the euro is in danger" or by considering the possibility of expelling a country from the euro area.

But it was not realized that, in the midst of a financial upheaval, such words are like fanning the flames and that the cost of the support package could only increase following such dramatic declarations.

By contrast, in other countries, leaders want to be seen as being in control of the situation and taking all sorts of initiatives to reassure their electorates. The media, of course, have a field day reporting on such apparently inconsistent activities.

What is clear is that Europeans have found out during this crisis that sharing a common currency entails much deeper links than they might have initially thought. Monetary union is to some extent also a political union and subject to the challenges that such unions face, possibly even on a larger scale.

Editor's Note: This piece is the first in a two-part essay adapted from Lorenzo Bini Smaghi's address at the 63rd Plenary Session of The Group of Thirty on May 28, 2010.

Read Part II here.