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A European tragedy

By Bill Lucarelli - posted Friday, 31 December 2010


A cloud of uncertainty has enveloped the future fate of the euro. After three decades in the construction of European Monetary Union (EMU), culminating in the birth of the euro in 1999, the whole edifice has been shaken to its very foundations by the recent sovereign debt crisis, which has engulfed the peripheral, deficit countries of the Eurozone (i.e., Greece, Portugal, Spain and Ireland). These profound asymmetrical shocks, emanating from the global financial crisis of 2007-09, could eventually threaten the internal cohesion of the Eurozone. The origins of the current crisis can be found in the longstanding internal contradictions that the system has inherited from its inception under the Maastricht Treaty of 1992 and the neoliberal strategy, which has governed its evolution.

The legacy of the Maastricht Treaty

In order to grasp the dynamics of the current crisis, it is necessary to understand the historical context and the institutional framework, which has defined the broad contours of Europe's descent into a state of semi-permanent economic stagnation. Europe's protracted structural crisis is the direct legacy of over 3 decades of neoliberal policies of disinflation, which have informed its evolution towards EMU, enshrined in the strict "convergence criteria" of the Maastricht Treaty and reinforced by the Stability and Growth Pact (SGP) of 1997. The peculiar institutional characteristics of the European Central Bank have created the conditions for this self-reinforcing and seemingly irreversible process of cumulative decline and stagnation.

In 1992, the Maastricht Treaty established the basic architecture for EMU and the institutional design of the European Central Bank, which was essentially modelled on the Bundesbank. In the absence of political union, the eventual birth of the euro in 1999, created a central bank that was entirely devoid of a corresponding fiscal framework or the existence of a common European Treasury, analogous to the US Treasury. At the same time, a quite narrow and arbitrary set of fiscal criteria were enshrined by the Maastricht Treaty, which have since imparted a powerful disinflationary impulse throughout the Eurozone. This fiscal straightjacket has been responsible to a large extent for Europe's prolonged phase of stagnation and high levels of unemployment.


In a rather inexplicable violation of the basic principles of central banking, the Maastricht Treaty's design of the European Central Bank (ECB) designated that the "lender of last resort" function should be prohibited. In other words, the ECB would be prevented from rescuing Member States in the event of a sovereign debt crisis. In short, the EMU is devoid of any mechanism which allows the Member States to monetise their fiscal deficits. Membership of the EMU has deprived the national central bank of the ability to purchase government bonds in exchange for base money. As a result, the privileges of seigniorage traditionally enjoyed by sovereign states by virtue of their monopoly over the issuing of fiat money, was effectively surrendered to the ECB.

This implies the very real possibility of national governments defaulting on their sovereign debt in the event of a major financial crisis. Since the sovereign debt is no longer denominated in the national currency or state money, but is now denominated in euros, national governments have not only surrendered their privileges of seigniorage, but also of the ability to monetise their deficits. The surrender of monetary sovereignty by national governments thus imposes unnecessary financial constraints since they are now impelled to borrow from capital markets in order to finance their deficits. This means that national governments have become captive to the dictates of financial markets in the formulation of national policy.

Consequently, in the absence of a supranational Treasury, analogous to the US system of governance, the Eurosystem ceases to have any mechanisms by which to monetise their fiscal deficits. This implies that each Member State has been deprived of the conventional Keynesian instruments of fiscal activism to maintain high levels of employment, especially in the event of a recession or an adverse asymmetrical shock. For the weaker, deficit countries, the choice becomes quite stark: either they default and exit the Eurozone, or they are compelled to adjust internally through the imposition of a severe program of austerity. Quite clearly, the institutional flaws inherited by the Maastricht regime and informed by monetarist/neoliberal economic doctrines, now act as a serious obstacle to a synchronised recovery of the Eurozone.

At the same time, the lack of a coherent fiscal policy regime on the supranational level has deprived national governments of their ability to implement counter-cyclical policies in the event of a recession. This fiscal straitjacket imposes incessant deflationary pressures and compels individual Member States to pursue destructive "beggar-thy-neighbour" policies of export-led growth. While the surplus countries, most notably Germany, enjoy lower interest rates on their issuing of sovereign debt, the deficit countries are confronted by a vicious circle of higher interest rates, credit downgrading and higher exposure to the risk of default, which pushes them into an unsustainable debt trap.

This perverse logic is further reinforced by Germany's insistence that it also pursue disinflationary policies domestically, thereby setting in train a deflationary spiral throughout the Eurozone. By doing so, the German authorities are enacting policies which depress the level of effective demand in the Eurozone and therefore have a negative effect on their exports. Indeed, the unwillingness of the surplus countries to provide an expansionary impetus in order to expand employment and aggregate demand in the Eurozone, appears to be ultimately self-defeating.

The supreme irony is that while Germany accuses the deficit countries of profligacy and "living beyond their means" it also relies upon these very same countries to generate demand for its industrial exports, which tend to be highly income-elastic. It is difficult to envisage how the weaker deficit countries will restore their export competitiveness in the absence of an exchange rate devaluation which is, of course, ruled out under the euro. The end result is a phase of debilitating deflation induced by policies of wage repression and rising unemployment. Wage repression in Germany has been ubiquitous and has set in motion a "race to the bottom" within the Eurozone.


Ultimately the burden of adjustment is borne by the European working class. The persistence of German balances of payments surpluses is increasingly based upon their ability to depress wages growth. The accumulation of these surpluses translates into an increase in foreign investment and bank lending to the deficit countries of the periphery. Since monetary policy is set by the ECB and fiscal policy is constrained by the Maastricht Treaty, the peripheral countries not only experience a deflationary adjustment, but are compelled to improve their international export competitiveness by savagely curtailing wages growth as well. It is, therefore, not too surprising that the peripheral states have become more reliant on private foreign borrowings from the core countries in order to finance their respective fiscal deficits

The fact that the ECB has been willing to purchase government bonds in the secondary bond markets rather than directly suggests that the original "no bail out" of insolvent governments has been temporarily suspended. This glaring dichotomy only serves to further highlight the flawed architecture of the Maastricht Treaty. In the absence of a common fiscal regime, analogous to the US Treasury, the European banking system is exposed to the risk of defaults by sovereign states. The potential "moral hazard" risks invoked by this scenario, compels the ECB to incur the ultimate risks by purchasing these bonds in the secondary bond markets.

This allowed the banking system to restore their balance sheets and increase their liquidity, even though renewed lending would not be assured in the event of the onset of a liquidity trap. The ultimate political and social costs, however, were incurred by the peripheral deficit countries that were forced to impose quite severe austerity measures in order to placate the private commercial banks.


If current policies of fiscal austerity continue to inform the macroeconomic stance of the governments of the Eurozone, it is quite possible that the peripheral deficit countries could experience a prolonged phase of debt-deflation. In this worst case scenario, the onset of deflation could set in motion a chain of events, which leads to the cessation of debt validation and the emergence of a severe economic slump. A cascading series of sovereign debt defaults could set in train this cumulative process of stagnation and decline. Consequently, the liquidation of debts acts as both a cause and a catalyst for the onset of debt-deflation. The more that debtors attempt to validate their obligations, the more difficult it becomes to liquidate their assets because of falling prices. Under these extreme circumstances, monetary policy becomes entirely ineffectual with the emergence of a pervasive liquidity trap, similar to the Japanese experience over the past 2 decades.

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About the Author

Bill Lucarelli is senior lecturer in the School of Economics and Finance at the University of Western Sydney.

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