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Understanding the Euro Crisis: Causes and Fixes

Understanding the Euro Crisis: Causes and Fixes

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Author

Tom McDonnell

Summary

The euro crisis was and remains a system problem. The roots of the crisis lie in a series of structural flaws in the architecture of European Monetary Union including in its design, construction and implementation. Notable design flaws include the absence of a centrally run banking union to accompany currency union, the absence of a fiscal mechanism to soften asymmetric shocks, and the absence of a conditional Lender of Last Resort (LOLR) for sovereign borrowers. An LOLR is an institution with the authority and resources to provide funding to otherwise solvent borrowers suffering from liquidity problems. The purpose of an LOLR within a monetary system is to prevent liquidity problems degenerating into solvency crises. Alongside these design flaws was an inadequate system of surveillance and regulatory mechanisms with too narrow a focus on overall price stability at the Eurozone level at the expense of other macroeconomic indicators such as localised credit expansion, financial stability, current account imbalances and economic growth and employment trends. As a result, destabilising credit flows and the build-up of regional imbalances within the currency union were allowed to expand unchecked. In this paper I argue that long-term success and stability for the currency union depends on the implementation of a package of complementary policy reforms to change the union’s flawed institutional architecture. Issues considered include the desirability of mandating a conditional LOLR for sovereign borrowers; the need for a banking union with a centralised authority mandated to supervise, regulate, and where appropriate shut down insolvent financial institutions; and the creation of a European deposit insurance corporation. Finally, the potential role for a centralised insurance fund available to member states to smooth out and ameliorate the severity of localised negative economic shocks and recessions is considered.

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