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The eurozone crisis:the theory of optimum currency areas bites back Barry Eichengreen

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The eurozone crisis:
the theory of optimum
currency areas bites back
Barry Eichengreen


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Lesson 1: Asymmetric shocks are intrinsic to monetary union
Lesson 2: Monetary union without banking union will not work
Lesson 3: A normal monetary union needs a normal central bank
Lesson 4: Labour mobility in monetary union is a mixed blessing
Lesson 5: Fiscal union has distributional consequences, making it untenable
Lesson 6: Fiscal stabilisation can be provided nationally only if debt overhangs are removed
Lesson 7: The eurozone needs a mechanism for restructuring unsustainable debts
Lesson 8: Monetary union is forever, more or less


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The eurozone crisis:
the theory of optimum
currency areas bites back
2011 was Europe’s annus horribilis, arguably the nadir of the
eurozone crisis. It was the year after the crisis surfaced in
what were initially dismissed as a handful of small countries
with special problems, starting with Greece, Ireland and
­Portugal, before infecting the monetary union as a whole. It
was the year preceding Mario Draghi’s “whatever it takes”
speech which laid to rest fears of eurozone break-up and
ended the acute stage of the crisis.
Ironically, 2011 was also the 50th anniversary of Robert Mundell’s classic article “The Theory of Optimum Currency
­Areas,” which provided the analytical framework through
which academics and policy makers think about preconditions for a smoothly functioning monetary union.1 Few other
articles published fully 50 years ago in the American Economic Review – much less articles running to just eight short
pages – have had such a powerful and enduring influence.
In fact, the coincidence of timing was just that, a coincidence.
That said, the two events were not entirely unrelated. The
theory of optimum currency areas, as developed by Mundell
and his followers, led by Ronald McKinnon and Peter Kenen,
contained important insights, which is of course why it remained so influential for 50 years.2 But the theory was also
incomplete and misleading in important respects, at least as
applied to the circumstances of Europe at the turn of the 21st
As articulated by Mundell, McKinnon and Kenen, the theory
of optimum currency areas emphasised convergence, labour
mobility and fiscal integration as preconditions for a smoothly
functioning monetary union.3 Convergence means greater
similarity in the economic structures of participating member
states, minimising the kind of asymmetric shocks that might
require a different monetary-policy response in different parts

of the monetary union (something that would not be possible
following the adoption of a common currency, by definition).
Labour mobility refers to the importance of encouraging
worker flows from high- to low-unemployment states as a
mechanism for adjusting to shocks in the absence of a national
monetary policy. Fiscal integration refers to the need to create
a system of budgetary transfers between (or budgetary coinsurance among) the participating member states, so as to aid
temporarily depressed regions that no longer possessed a
­national currency to depreciate and therefore had limited
scope for exporting their way out of difficulties.
These were important insights, which is why they remained as
influential as they did for 50 years. But the theory, having been
articulated at the middle of the 20th century, was ominously silent about important economic aspects of the 21st. And having
been developed to explain the smooth operation of monetary
union within existing federations like the USA and Canada
(both Mundell and McKinnon, recall, were ­Canadian), the
theory was also silent about the political prerequisites for a
smoothly functioning European monetary union.
Specifically, the theory of optimum currency areas and the literature that developed around it said nothing about banks as
propagators of asymmetric shocks or about the need for
banking union to accompany monetary union, since banking
systems at mid-20th century were still tightly regulated and
constrained in their operation. It said nothing about the selective emigration of the most skilled workers from the members of the monetary union experiencing adverse shocks,
since exceptionally deep and long-lived shocks of the sort suffered by the members of the eurozone periphery starting in
2010, which might lead to a serious brain drain, were not anticipated by the theory’s fathers. It said nothing about the


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need for the central bank in the monetary union to act as a
lender of last resort or about the need for it to backstop the
bond and financial markets of the individual member states,
since serious sovereign debt and banking crises like those of
the 1930s were only a distant memory. It said nothing about
the desirability of a mechanism for the orderly restructuring
of sovereign debts in an environment where participating
member states inherited a debt overhang and had no recourse to the inflation tax, since the debts of existing monetary union members (US states and Canadian provinces, of
course, being everyone’s favourite example) did not begin to
approach the levels reached in eurozone member states subsequently. It said nothing about the reversibility of monetary
union, since the idea that a member of the US or Canadian
monetary unions might exit was not part of 1960s discussion.
And it said nothing about how much further political integra-

tion might be required for fiscal integration, or alternatively
whether the limited fiscal integration that was compatible
with limited political integration would be enough to support
the smooth functioning of Europe’s monetary union.
The remainder of this paper enumerates eight lessons of the
eurozone crisis not anticipated by the fathers of the theory of
optimum currency areas for the smooth operation, or otherwise, of Europe’s monetary union. 4 The purpose is not simply
to show where the founders of optimum currency area theory
went wrong. Assembling those lessons also has a positive purpose, namely to derive implications for Europe’s success in
drawing a line under its crisis. Those implications, and whether
policy makers show resolve in addressing them, are directly
relevant to investors choosing to bet for or against the monetary union and for or against the successful revival of E
­ urope’s

Lesson 1.
Asymmetric shocks are intrinsic
to monetary union
The theory of optimum currency areas took the symmetry or
asymmetry of aggregate disturbances across the countries or
regions potentially participating in a monetary union as a
given. That is, it took the pattern of disturbances as an exogenous criterion to guide the decision of whether or not to form
a monetary union and, if that decision was positive, as a guide
to what the contours of the monetary union would be. Thus, in
his original article Mundell speculated that Canada’s western
provinces together with the western US states might constitute a natural monetary union, given similarities in their resource endowments and the sharp differences in industrial
structures between the eastern and western parts of North
America. My own work with Tamim Bayoumi (Bayoumi and
Eichengreen 1993) estimating the symmetry of aggregate

supply and demand disturbances across European countries
and US regions similarly took the pattern of disturbances as
given, although we also speculated about how such correlations might change in the future.
There were three notable exceptions to this exogeneity rule.
First, Frankel and Rose (1998), writing on the eve of
­Europe’s monetary union, pointed out that European integration, extending to monetary integration, might lead to
changes in the industrial structures that Mundell emphasised as the source of asymmetric shocks. If integration resulted in more inter-industry trade, regions might become
even more specialised in different industries, leading to even
more asymmetric shocks (insofar as shocks are industry-­
specific). If it led mainly to more intra-industry trade,


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r­egional industrial structures might overlap more than
­before, leading to less asymmetric shocks. Analysing the
connections between the growth of trade and the inter-­
regional correlation of business cycles led them to conclude
that intra-industry trade and more symmetric shocks would
dominate. Not to worry, in other words.
A second exception was the literature that attributed asymmetric shocks not to different industrial structures per se but
to the different levels of economic development associated
with those shocks and with other tensions in the monetary
union. The problem was the large gap in development between Europe’s core and periphery; the corresponding solution was policies of cohesion (structural fund transfers to
­finance infrastructure spending) and policy discipline (like
that conferred by monetary union membership), which would
permit the economies starting out behind to catch up. Here
the evidence from the 1990s suggested that cohesion was
working and that the convergence process was in fact underway (see inter alia Crespo-Cuaresma and Ritzberger-­
Grunwald 2005, Jelnikar and Murmayer 2006). Again, the
­reassuring conclusion was not to worry.
The third, unsettling exception was Walters (1990), who
warned that inflation rates were unlikely to converge quickly
across the members of the monetary union. In particular, inflation would continue to be higher at Europe’s periphery.
This might be a fundamentally healthy phenomenon insofar
as the prices of nontraded goods rise faster in fast-growing
peripheral economies (a tendency known as the Balassa-­
Samuelson effect). Or it might be unhealthy insofar as the
poor economies of the eurozone periphery continued to
pursue lax fiscal (and other) policies with inflationary consequences. Either way, if a single level of nominal interest
rates prevailed throughout the monetary union, as it should,
the result would be lower real interest rates at the periphery,
leading to an unsustainable consumption and investment
boom, ultimately with destabilising consequences.
This was a prescient warning. Much as Walters had forecast,
the countries at the periphery of the eurozone saw booms in
construction spending (Ireland, Spain), consumption spending (Portugal) and government spending (Greece), as the
cost of borrowing for households, firms and governments
came down. Their spending booms were financed by large
capital flows from the monetary union’s core to its periphery, and they were reflected in equally large current account
deficits for the eurozone periphery and surpluses for the
core. When doubts arose in 2009-10 about the sustainability
of the process, those capital flows came to a sudden stop, imparting a destabilising asymmetric shock.

The clear implication, emphasised by Walters, was that this
asymmetric shock was intrinsic to the operation of the monetary union. It was not simply bad luck, an asymmetric draw
from the macroeconomic urn. Rather, it was fundamentally
connected to the real-interest-rate effects of monetary unification. Why Walters’ warning was not heeded is unclear even
now. It could be that a warning coming from a strident
­Euro-sceptical critic was easier to dismiss than warnings from
more sympathetic Continental quarters.5 With hindsight it is
clear that this source of intrinsic asymmetric shocks to the
stability of the eurozone was not paid adequate attention.
The policy implication is that cross-border capital flows and
current account imbalances within the eurozone cannot be
treated with benign neglect. Those capital flows enable public and private sector excesses in the countries on the receiving end. They expose the economies of the recipients and
the banking and financial systems of the suppliers to disruptions when doubts arise about the sustainability of the process. These problems will be especially acute within a monetary union where there are no impediments to capital flows
and no exchange risk to deter cross-border borrowing and
lending. They will therefore require a policy response.
The EU, having learned this lesson the hard way, is now moving in the requisite direction. In December 2011 it introduced
a Macroeconomic Imbalance Procedure as part of the socalled “Six Pack” of reforms, portions of which are now embedded in the Fiscal Compact. That procedure consists of a
scoreboard of early warning indicators, of which the threeyear backward moving average of the current account balance is one, then an in-depth analysis of countries with unfavourable indicators, and finally an Excessive Imbalance
Procedure for countries with imbalances that jeopardise the
functioning of the eurozone.
As always, the proof of the pudding is in the eating. In this
case the eating depends on what steps will be taken to forcefeed distasteful portions to countries reluctant to ingest them.
Regulation No. 1174/2011 on “enforcement measures to correct excessive macroeconomic imbalances in the euro area”
relies, unfortunately, on the same weak sanctions that have
not worked in the case of the Stability and Growth Pact.
­Violators are required to make deposits of 0.1 percent of
GDP that convert into annual fines in the case of continued
noncompliance. The decision to apply sanctions is made by
the Council on a recommendation from the Commission.
Logic suggests that member states will be reluctant to fine
themselves. There is now more than a decade of historical experience with the Stability and Growth Pact that points in the
same direction.


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More comprehensive macroeconomic surveillance is all to
the good. But recent institutional innovations bearing on
enforcement are not reassuring. Europe would have a
brighter future if these weaknesses were addressed.
The other way of attempting to limit the booms and busts

caused by destabilising cross-border capital flows and current account imbalances within the eurozone is by regulating the banking systems that are the conduit for these flows.
This in turn brings us to a second important lesson of the
eurozone crisis.

Lesson 2.
Monetary union without banking
union will not work
That monetary union requires banking union – a single financial rulebook, a single bank supervisor, an adequately funded
single resolution mechanism for bad banks, and harmonised
deposit insurance – seems obvious in light of recent events.
Europe’s financial system is heavily bank based. Banks play
an important role in cross-border capital flows in the eurozone.6 Supervision and regulation in one country that does
not adequately take into account the cross-border implications of the home banks’ lending policies can have destabilising implications for its neighbours.
Similarly, the absence of a mechanism for the orderly resolution of insolvent banks leaves only bailouts as an alternative.
This fosters moral hazard, leaves problem banks undercapitalised, threatens the solvency of the sovereigns responsible
for recapitalisation, and gives rise to the spectre of zombie
banks and firms. Insofar as the problem of inadequate capitalisation and resolution are neglected, confidence in the
banking system as a whole can be damaged, and that damage
may not be limited to the initiating country.
These problems are common to a financially globalised
world, but they are especially pervasive in a monetary union
with a single financial market, where there is neither exchange risk nor significant statutory impediments to bank-­
intermediated cross-border capital flows. Early work on the
theory of optimum currency areas neglected these dangers

for the simple reason that banks were tightly regulated and
cross-border lending and borrowing was strictly limited in
the 1950s and 1960s.
Like it or not (and not all politicians and publics like it), the
eurozone’s progress on completing its banking union is a key
litmus test for whether Europe will face brighter growth
prospects and a superior combination of growth and stability
going forward.7 Here again, Europe talks the talk but doesn’t
walk the walk. There is a shared commitment to create a fullfledged banking union, but there is less than full agreement
on the details.
Fully analysing the challenges of creating an effective banking union would require a paper (or papers) of its own. But
the key points run as follows. First, the emphasis of policy
makers on, inter alia, banning proprietary trading by the
largest banks risks neglecting more important issues. More
important would be regulations addressing the risks posed
by the excessive concentration of sovereign debts in the
portfolios of domestic financial institutions. Ceilings could
be placed on domestic sovereign debt held by banks. More
flexibly, the risk weights attached to domestic sovereign debt
could be conditioned on the extent of the banks’ exposure.
Second, the workability of a system in which the ECB supervises “significant” credit institutions while national authorities remain responsible for supervising the rest remains to be


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established. National supervisors and the ECB are supposed
to coordinate seamlessly and share information, hand in
glove. Time will tell.
Third, the decision making process envisaged in the proposed
Single Resolution Mechanism is overly complex, and an adequate financial backstop will not exist for years. A decision to
place a bank in resolution would involve the board of the Single Supervisory Mechanism (24 members), the ECB Governing Council (24 members), and possibly the boards of the Single Supervisory Mechanism Mediation Panel (3 members),
SSM Executive Board (10 members) and Single Resolution
Mechanism Board (23 members) – after which the Council
(28 members) would have to give its assent, based on a proposal by the European Commission (28 members). A commitment to establish a common backstop of EUR 55 billion
by 2025, or even 2019, is too little, too late.8 In the meanwhile,
the resolution fund will be split into national compartments;
the effective resolution regime as a result will not differ significantly from the status quo. In particular, it will do nothing
to break the “diabolic loop” connecting banking and sovereign debt problems. This is not a single resolution regime in
any meaningful sense of the term.9
Coming finally to a harmonised or single deposit insurance
scheme, it is important to recognise that the rationales for
harmonised and single insurance are different. Harmonising
national deposit insurance schemes is designed to prevent
eurozone members from adopting beggar-thy-neighbour in-

surance policies (as when Ireland raised its deposit insurance
ceiling in 2008 and drained deposits from other eurozone
banks). Some steps have now been taken in the direction of
further harmonisation (the EU has harmonised minimum
levels of deposit insurance coverage and maximum payout
periods), but the basic problem of beggar-thy-neighbour policies remains unaddressed.10
In contrast, the argument for a single deposit insurance
scheme backed by a common fund is that the funding available at the national level may not be adequate. Efforts to
move to a single scheme have foundered on German opposition, however, the fear there being that fees paid by German
banks (and passed on to their customers) will be used to bail
out reckless banks in other countries. But it should be incumbent on those opposing a single insurance scheme to offer an
alternative. The alternative is to prevent bank liabilities from
growing so large that they exceed the resources of the national insurance fund and the capacity of the sovereign to
top it up. But German opposition to a single scheme has not
resulted in pursuit of this alternative. Until one or the other
option is pursued, Europe’s banking union will remain incomplete.
The best that can be said is that Europe’s banking union remains a work in progress, the implication being that faster
progress is now needed. The worst that can be said is that this
is a pale imitation of a true banking union, which does not
bode well for the euro’s future.

Lesson 3.
A normal monetary union needs
a normal central bank
The fathers of the theory of optimum currency areas did not
address the question of what exactly the common central
bank should do. In this case, at least, the sins of the fathers did

not automatically translate into the sins of the children. Already in 1992, Folkerts-Landau and Garber argued that a
­European Central Bank would have to do more than follow a


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monetary policy rule (whether a money supply growth rule, a
Taylor rule, or an inflation target rule). In addition it would
have to be cognisant of its role as lender and liquidity provider of last resort, of its responsibility for the stability of
­Europe’s payments system, and of its contribution toward supervising the banking system.11
With hindsight, this was another prescient diagnosis and
warning, right up there with that of Alan Walters, not that it
was taken to heart. In its first decade, the ECB focused narrowly on its inflation target (along with, initially, the money
supply target that constituted the second pillar of its monetary policy strategy) to the all but total exclusion of other considerations. Under the leadership of Jean-Claude Trichet, the
central bank famously raised its policy rate twice in the spring
and summer of 2011 in response to a temporary deviation of
headline inflation above its 2 percent target, despite the fact
that European banks, sovereigns and economies were already
reeling from the crisis.
The central bank’s stance then changed with the transition
from Trichet to Draghi, with the new central bank president’s “whatever it takes” remarks in the summer of 2012,
and the ECB’s programme of Outright Monetary Transactions, in which it promised to purchase the bonds of eurozone sovereigns on the secondary market if disorderly conditions threatened the operation of the payments system,
interfered with the transmission of monetary policy, and
raised doubts about the cohesion of the eurozone.12 The
preceding period had seen what looked like a self-fulfilling
panic, where collapsing bond prices led to doubts about sovereign finances and bank solvency, which then fed on themselves. OMT was enough to put this panic to rest. That its
mere announcement was sufficient to calm the markets is
impressive evidence of the stabilising influence of a central
bank prepared to act as a lender of last resort.
Press reports had Bundesbank President Jens Weidmann and
other members of the ECB Governing Council opposing
OMT on the grounds that it would weaken the commitment
of member states to reform. This past February the German

Constitutional Court then opined that the ECB had massively exceeded its competences and mandate with OMT.13
This raises questions about whether the ECB will engage in
lender-of-last-resort type operations in the future. More fundamentally, it points to the question of whether it is properly
the function of a central bank to apply pressure on governments to pursue structural reforms. That the ECB participates in the Troika, applying pressure for reform in return for
financial assistance to troubled sovereigns, creates a conflict
with its other objectives. This has led some to suggest, not
without reason, that the ECB, as a normal central bank,
should not participate in future Troika-like arrangements in
order to focus on its core mandate.14
The ECB also remains slow to react to the risk of deflation.
Since those mid-2011 interest-rate hikes, policy remains
tighter than counselled by a textbook Taylor rule. Now that
the zero lower bound is binding, the ECB is reluctant to turn
to unconventional monetary policies. It remains disinclined
to embrace the Bernanke doctrine, which counsels acting
preemptively to prevent deflation from developing in the
first place, since once it develops it may be extremely difficult to dispatch.15 This is another notable departure from
what is now regarded in most circles as normal central banking practice.
It may be that the ECB’s focus on headline rather than core
inflation allows it to be distracted by volatile food and fuel
prices. It may be reluctant to antagonise important shareholders like Germany, where inflation is running above the
eurozone average and scepticism abounds about unconventional monetary policy. A Governing Council of 24 members
may be too large and unwieldy to act swiftly and preemptively. Ten years ago the ECB put forward a proposal for restructuring country representation on the Council into constituencies, but no progress has been made on that front.16
Until these issues are addressed, the ECB will remain less
than a normal central bank. And continuing unwillingness
to address them does not bode well for the future of the
euro and the European economy.


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Lesson 4.
Labour mobility in monetary union
is a mixed blessing
Mundell emphasised labour mobility as an alternative to
changes in monetary policy and exchange rates in adjusting
to region-specific shocks. In 1992 Blanchard and Katz then
documented the importance of labour flows between the 50
US states as a mechanism for adjusting to state-specific disturbances.17 The fact that migration within the eurozone is

­ oungani (2014) show that even the relatively strong migraL
tory response in the USA has been insufficient to prevent
sharp increases in unemployment and reductions in the
­labour force participation rate in particular regions.
Migration as a mechanism of adjustment has been especially
problematic in the context of the Great Recession. Insofar as
lower than in the USA is a commonplace. Only 0.3 percent
the recent shock was global rather than local, there were few
of the population of the EU-27 states moved across national
booming regions for the residents of depressed regions to
borders in 2010. This compares with the 2.4 percent of the
­migrate to. This may be part of the explanation for why the
total population of the USA that relocated across state lines,
migratory response to the crisis and subsequent recession was
and 1.5 percent cross-territory movement in Australia.
not greater.18 The same point can be made specifically about
Meanwhile, less than 1 percent of the total population
Europe, where a significant share of emigration by the resimoved across the NUTS-1 regions of Europe (the largest
dents of, inter alia, Spain, Portugal, Italy and Ireland has been
national subregions distinguished in EU statistics) accordto extra-European destinations – Latin America in the first
ing to the OECD.
three cases, English-speaking economies in the fourth. Other
Explanations for the contrast with the USA point to differauthors have pointed to the weak housing market as another
ences in language, limited access to local healthcare and benpossible culprit, since homeowners may be unable to sell their
efits, and uncertainties regarding the transfer of pension
houses in depressed markets and be reluctant (or in the
rights. These observations lead in turn to recommendations
­European case, unable) to sell a home whose value is less than
for streamlining regulatory requirements for vesting periods
its mortgage, although this conclusion has also been disputed.
in pension plans and eliminating barriers to access to healthBe this as it may, the kind of severe global shock experienced
care and benefits for foreign workers. But the fact that migrain Europe after 2008 was not what the fathers of the theory of
tion is low even within EU countries, where linguistic differoptimum currency areas had in mind when they trumpeted
ences and vesting and access problems are not obstacles,
the advantages of labour mobility. Nor did they anticipate the
suggests that something more is at work. Still, the implication
collapse of housing prices in the crisis economies.
follows that the eurozone either needs to do more to encourIn addition, structural changes, such as the role of informaage labour mobility, or else it must develop other mechanisms
tion technology in creating job opportunities in a variety of
– greater wage flexibility or compensatory fiscal transfers, for
locations, dual career families, and polarisation of the labour
example – to deal with concentrations of unemployment.
market may also be making for a long-run secular decline in
Recent experience has cast the role of labour mobility within
labour mobility. Dao, Furceri and Loungani (2014) document
monetary union in a less favourable light. First, it has shown
a decline over time in both the unconditional gross migration
labour mobility to be a less powerful mechanism of adjustrate and the net inter-state migration rate conditional on
ment in the context of major shocks. Dao, Furceri and­ shocks in the United States.19 They speculate that financial


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i­ntegration (the relaxation of restrictions on interstate banking, for example) may have increased the correlation of regional business cycles, reducing the incentive for, and efficacy
of, migration (something that has obvious implications for
­Europe, given the financial integration attendant on the euro).
Just as labour mobility may be a less effective mechanism of
adjustment in the case of major shocks, these other changes
may make it less effective in the future than in the past.
The selective nature of migration raises troubling issues. Outmigration from Spain, Italy and Greece is dominated by the
emigration of relatively high-skilled individuals, who have
relatively portable credentials and more knowledge of foreign job opportunities.20 Ciccarone (2013) similarly points to
evidence of a rise in the share of higher-skilled emigrants
from Italy. As a result of the crisis, the higher-skilled mobile
population within the EU has become increasingly concentrated within the so-called core countries at the expense of
the periphery (Holland and Paluchowski 2013).
This brain drain can have a permanent negative effect on the
productive potential of the sending economies. In turn, that

negative productivity effect can have a reinforcing impact on
competitiveness and unemployment in the adversely affected
regions (Brezzi and Piancentini 2010). In addition, the outmigration of the most skilled can weaken the incentive for the
adversely affected regions to invest in skills and training, with
further negative implications for their competitiveness.
It is relevant in this context to recall that Blanchard and
Katz’s classic article on the role of labour mobility in the
United States was entitled “Regional Evolutions,” not
­“Regional Cycles.” Already in 1992, in other words, they were
warning that temporary regional shocks could produce permanent regional decline through the operation of these
mechanisms. Permanent decline of the population and economy of a city (Detroit) or a state (Michigan) might be politically tolerable in the United States. But the hollowing out of
a national economy through outmigration with reinforcing
negative effects would not be acceptable in Europe. Measures to enhance labour mobility will not be enough to solve
the eurozone’s problems. On the contrary, they may only end
up aggravating them. Alternatives should be sought.

Lesson 5.
Fiscal union has distributional
consequences, making it untenable
Seminal contributions to the theory of optimum currency
areas pointed to transfers accomplished through a federal
system of taxes and budgetary transfers as the alternative to
labour mobility. A limitation of this early work was that it
did not consider the redistributional impact of this kind of
fiscal system, simply assuming that transfers in one direction
in one period would be offset by transfers in the other direction in the next. Subsequent work by Bayoumi and Masson
among others then documented that there were large ongoing transfers associated with existing fiscal systems, with im-

portant distributional implications.21 As they showed, while
federal taxes and transfers have a significant stabilisation effect on US regions (they offset 31 cents of every USD 1 decline in regional income), they also have a permanent redistributional effect (of 22 cents on the dollar) from high to low
income states and regions. In Canada the stabilisation effect
(at 17 cents) is smaller, but the redistributive effect (at 39
cents) is even larger. Residents of European countries will
be familiar with this redistributive aspect of national fiscal
systems from the ongoing transfer of resources from west-


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ern to eastern Germany and from northern to southern Italy.
Eurozone members might agree to a fiscal system that implies ongoing redistribution were it negotiated “under the
veil of ignorance” – that is, if they had no idea whether they
would be on the sending or receiving end. In practice, however, there exist strong priors, whether rightly or wrongly, in
Germany in particular about who the givers and getters will
be in any prospective “transfer union.”
In theory, one could imagine designing a fiscal system for the
eurozone in a way that provides insurance against shocks but
is “actuarially fair” – that does not entail ongoing redistribution across member states. But this is easier said than done.
Pisani-Ferry, Vihrala and Wolff (2013) consider a number of
schemes, none of which turns out to be redistribution-free in
practice. A first scheme transfers corporate taxes (levied on
corporate earnings at a rate of 12.6 percent) from the national budget to the EU budget, using the resulting revenues
to pay the costs of unemployment compensation in the member states. This would provide insurance against shocks to unemployment. But it would also result in large transfers from
states with profitable corporations to states with high unemployment rates and generous unemployment insurance
The redistributive effect of such a scheme could be limited
by harmonising unemployment benefit systems across countries (some member states like Belgium providing much
more generous benefits than others), keying the system to
the change in the unemployment rate rather than its level
(some countries like Spain having higher recorded unemployment rates in normal times), and making payments into
the common fund a function of the change in corporate
earnings relative to some baseline (so countries with more

profitable corporations would not automatically pay more
– they would only pay more if their corporations became
even more profitable). But this approach – not compensating Spain for its higher unemployment and not taxing
­Germany’s more profitable corporations – would create political problems of its own.
Wolff (2012) suggests instead keying transfers to the output
gap (the deviation of GDP from potential), limiting their
cost by only transferring resources when the output gap exceeds 2 percent of GDP, and avoiding moral hazard by providing only partial insurance (in the amount of 25 percent of
the output gap). Such a system would provide only incomplete insurance against shocks. It would be redistribution-­
free only if the output gap is calculated in such a way that its
average value was the same in all countries and the frequency with which it exceeds 2 percent of GDP is similarly
the same across countries. In practice, however, output is
bound to be more volatile in some countries than in others
(just as it is more volatile in some US states and Canadian
provinces than others). In this scheme, states with volatile
economies would be the disproportionate recipients of
transfers. Such a result might be economically desirable, but
it would not be politically acceptable.
The bottom line is that it is all but impossible in practice to
detach the redistributive effect of this kind of integrated fiscal
system from its insurance effect. Given that the eurozone’s
fiscal system would not be created under a veil of ignorance,
this makes establishment of such a system unlikely in practice. Someday, when Europe has moved to deeper political
integration and national identities have given way to a common European identity, things might be different. But not for
the foreseeable future.


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Lesson 6.
Fiscal stabilisation can be provided
nationally only if debt overhangs are removed
The obvious alternative to coinsurance through a eurozone-wide system of taxes and transfers is for members of the
monetary union to self-insure. This brings us to the prickly issue of the countercyclical national fiscal policies, the idea that
governments should run surpluses in boom times and deficits
in slumps. The argument that governments should have more
freedom to adjust national fiscal policy when all freedom to
adjust national monetary policy is absent (as in a monetary
union) and other adjustment mechanisms (like labour mobility and fiscal integration) are lacking is straightforward in
principle. But it is not straightforward in the European context, where the argument for countercyclical (“Keynesian”)
fiscal policies is not universally accepted. It is not straightforward because there is a lack of confidence that governments
can be trusted to utilise their fiscal instruments in desirable
ways. And it is not straightforward because inherited debt
overhangs limit governments’ fiscal room for manoeuvre.
The debate over whether fiscal policy has real effects or
crowds out private-sector spending one-for-one has a heavy
ideological component and cannot be resolved here, although
recent work by the IMF would seem to provide strong evidence of real effects in the European context.22 The EU has
attempted to address concerns about the opportunistic use of
fiscal policy by distinguishing automatic fiscal stabilisers,
which should be allowed to operate, from discretionary
changes in fiscal policy, which it hesitates to authorise. The
Fiscal Compact (technically, the Treaty on Stability, Coordination and Governance in Economic and Monetary Union)
in place since January 2013 limits the permissible “structural”
budget deficit (adjusted for the business cycle) to ½ percent
of GDP but allows countries to run larger deficits to the extent that these result from cyclical downturns that reduce tax
receipts and raise transfer payments.

The Fiscal Compact is a step in the right direction relative to
the Stability and Growth Pact that preceded it. It provides
more flexibility for fiscal policy over the cycle. It provides
more credibility in that its budget balance rule must now be
embedded in the national constitutions or made a matter of
binding national law in each member state. But it provides
neither enough flexibility nor enough credibility for the circumstances at hand. Automatic fiscal stabilisers provide only
partial insurance against asymmetric national shocks; studies
like Bayoumi and Eichengreen (1995) and Wyplosz (2002)
show that they compensate for only a third to a half of an output decline. Tax reforms that accentuate the cyclical sensitivity of revenues (by, for example, relying more on capital gains
taxes, which vary strongly with the cycle) would strengthen
automatic stabilisers but would be politically divisive.
There are worries, moreover, that even cyclically-adjusted
budget balance rules embedded in national constitutions
lack credibility. Governments are prone to overestimating
revenues – to forecasting too small an output gap – and
therefore to underestimating realised deficits. Old problems
of excessive deficits will therefore be quick to return, the argument goes. The solution to this problem suggested by
Frankel (2013) is to outsource the forecast to an independent committee or agency and require the government to formulate fiscal policy on the basis of its forecast.23 The Treaty
requires member states to create independent institutions
to monitor compliance with the Fiscal Compact. It could
usefully go a step further by delegating the forecasting function to such institutions and mandating that governments
utilise the resulting forecasts.
The other obstacle to letting automatic fiscal stabilisers operate is the inherited debt overhang. A cyclical downturn
that widens the budget deficit and causes the debt-to-GDP


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ratio to rise would create renewed concerns about debt sustainability given very heavy inherited debt loads in Southern European countries. Spreads on sovereign bonds would
rise, widening the deficit still further, and pushing up other

interest rates, crowding out investment. Fiscal self-­insurance
remains a logical alternative to fiscal coinsurance in a
­monetary union, but only if the existing debt overhang is
first removed.

Lesson 7.
The eurozone needs a mechanism for
restructuring unsustainable debts
It follows that the eurozone needs a mechanism for removing
debt overhangs if automatic fiscal stabilisers are to be allowed to operate in stabilising ways. To this end, Hans-­Werner
Sinn has called for a one-time debt conference, in which the
creditors of Southern European governments and banks will
forgive a significant part of the debt.24 In cases like Greece,
where the majority of sovereign debt is now in the hands of
official creditors like the ECB, such a conference might be
small and have a relatively good chance of succeeding.25 Were
it to also consider the debts of other Southern European
member states, where the bulk of sovereign debt is still in private hands, negotiations would be messier and more difficult
to bring to a successful conclusion.26
In these circumstances, it makes sense to rely on incentives
and market-based mechanisms rather than imagining that,
in some mythical debt conference, reasonable minds would
prevail. The Greek debt exchange and other market-based
debt exchanges before it have shown how such incentives
can be deployed. Greece provided incentives for bondholders to agree to the terms of its debt exchange by offering a
menu of new bonds and an upgrade in governing law
(English law rather than Greek law governing the new
bonds). Other countries have used exit consents (new financial covenants and waivers of sovereign immunity voted by
a qualified majority of bondholders) to achieve the same
end.27 More generally, the Greek debt exchange demon-

strated the feasibility of market-based approaches to debt
restructuring in the eurozone. Generalising the approach to
other countries where heavy debts are an obstacle to the use
of automatic fiscal stabilisers (in blunt language, proceeding
with market-based sovereign debt exchanges in other countries like Portugal) would help to lay the basis for a more
stable eurozone going forward.
Until now, there has been a reluctance to follow this market-­
based approach. Some critics question the ability of sovereigns to mobilise the requisite investor participation and
worry about disruptive legal action by holdouts. Others warn
of destabilising consequences for banks, while still others caution against damaging the future ability of governments to
borrow. Whatever the explanation, there is a temptation to
turn instead to bailouts. Even when there is ultimately a recognition that restructuring is unavoidable, that recognition
comes too late.28 This is a global problem, but it is especially a
problem in the eurozone, where there is unusually great
scope for contagion, members have fewer other mechanisms
for dealing with debt crises, and the existence of the E
­ uropean
Stability Mechanism opens the door wide to the bailout alternative. The Committee for International Economic Policy
and Reform (2013) therefore recommends amending the
ESM Treaty to provide sovereign immunity from legal action
by holdouts if a restructuring is approved by the ESM. In addition, it suggests amending the Treaty to make debt restruc-


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turing a precondition for ESM lending when sovereign debts
exceed a pre-set level (say, 60 percent of GDP).
A sovereign debt restructuring mechanism at the global level,

as proposed by Krueger (2001), remains pie in the sky. But
Europe already has treaties governing closely related matters
that could be amended to address this important question.

Lesson 8.
Monetary union is forever,
more or less
Since the euro crisis erupted in 2010, there have been many
forecasts of exit by troubled member states, none of which
has come to pass. There continue to be proposals for temporary “sabbaticals” from the euro for countries finding it
difficult to restore growth and competitiveness (Feldstein
2010, Sinn 2013), which similarly have not been taken up by
policy makers. The fact that the eurozone has not collapsed
is not simply a matter of good luck, however. Similarly, the
reluctance of countries like Greece to take a holiday from
the euro is not simply a matter of intransigence on the part
of policy makers. What we have learned from more than
three years of crisis is that, like it or not, monetary union is
To put the point in more nuanced form: while adjustment
within the eurozone is difficult and costly, adjustment through
exit would be even more difficult and costly. The idea that a
country can temporarily suspend its eurozone membership
and adjust by depreciating its newly reintroduced national
currency is predicated on the analogy with the classical gold

standard, when countries that temporarily suspended gold
convertibility committed to returning at the previous parity.29
In the current context, in contrast, there would be no commitment to return at the earlier rate of conversion between the
national currency and the euro; on the contrary, some proponents of the “holiday” idea propose precisely the opposite,
namely returning at a depreciated rate.
Hence talk, much less the reality, of a euro holiday would provoke capital flight, a banking crisis and emergency resort to
exchange controls, which history has shown are easier to impose than to remove. This would be the mother of all crises,
something that governments would be understandably anxious to avoid. It is not a coincidence that proposals for a temporary holiday from the euro, much less scenarios of unilateral exit and wholesale eurozone break-up, have been
avoided. Politicians can still miscalculate. But rational calculation points to the conclusion that breaking the euro up
would be even more costly than holding it together. Nothing
is irreversible. But Europe’s monetary union comes close.


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Our eight lessons of the eurozone crisis for the theory of optimum currency areas lead to the following implications relevant to investors and policy makers. First, the initial design of
the eurozone was flawed and incomplete because the analytical framework on which it was based, the theory of optimum
currency areas, was flawed and incomplete. It neglected the
role of banks and capital flows in generating asymmetric
shocks. It overlooked the importance of banking union as a
concomitant of monetary union and the need for a multilateral surveillance process focusing not just on budget deficits
but also on credit booms, capital flows and current account
imbalances. It underplayed the need for a lender of last resort, envisaging the European Central Bank as a monetary
rule rather than guarantor of Europe’s payments system and
source of emergency liquidity. This created a tension that continues to pervade the ECB even today.
Moreover, the euro’s architects placed too much faith in labour mobility and wage flexibility (which in the present context is referred to as “internal devaluation”) as mechanisms
of adjustment, because they did not foresee the kind of deep
and enduring slump that could create a brain-drain problem
for Southern Europe and rend the social fabric on whose basis wage bargains are made. They did not pause to contemplate that Europe lacked the political preconditions for establishing a fiscal federation to complement its monetary
union, and that it was similarly unprepared to empower member states to substitute fiscal stabilisation at the national level
for the monetary instrument now foregone. Automatic fiscal
stabilisers might yet provide fuller insurance against asymmetric shocks within the monetary union, but only if the debt
overhangs inhibiting their operation are removed. But the
framers of the theory of optimum currency areas could not
imagine that the members of a monetary union would be bur-

dened with debts as heavy as Europe’s today. Hence they –
and the European policy makers who adopted their perspective – did not propose a mechanism for restructuring
unsustainable debts as part of the architecture of the monetary union.
European decision makers, having now learned the hard way
about the flaws in their analytical framework and initial design, have moved some way toward rectifying these problems.
But our eight lessons also point out the extent to which progress remains incomplete. The Macroeconomic Imbalance
and Excessive Imbalances Procedures designed to address
problems associated with capital flows and current accounts
are a step forward, but enforcement remains questionable.
Europe’s banking union is most charitably described as a
work in progress, where the progress is less than impressive
and much work remains to be done. The Fiscal Compact, by
allowing governments to target cyclically adjusted budget
deficits of no more than ½ percent of GDP and embedding its
rules in national constitutions, is similarly a step forward. But
given the ability of governments to manipulate growth and
revenue forecasts, the failure to delegate the forecasting function to an independent commission and to require governments to make policy on the basis of those forecasts is troubling. Given inherited debt overhangs, allowing the automatic
fiscal stabilisers to operate remains problematic. And the
­eurozone still lacks a mechanism for the orderly restructuring
of unsustainable debts, which could in principle be added to
the ESM Treaty.
Breaking up the euro is not an attractive option. This leaves
fixing it as the only alternative. But given the slow and partial
progress Europe has made in putting the relevant fixes in
place, it is hard to bet on a quick resumption of rapid growth.
A better bet, given this slow and partial progress, is a lost dec-


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ade. The good news is that Europe is already half way there.
This suggests that there will come a time in the not-too­distant future (perhaps five years from now or, given the
­incentive to get in early, a bit sooner) when it will become
­attractive to begin investing in Europe again.
And what happens if European policy makers fail to make
progress in putting the relevant fixes in place? What would be
the implications of a breakdown in efforts to complete a
meaningful banking union, to restructure debts and renationalise countercyclical stabilisation policy, and empower the
European Central Bank to act as a true lender of last resort,
as needed to complete Europe’s common monetary house?
In this case, the implications for investors are dire and, necessarily, highly uncertain. One scenario would be an even longer
period of stagnation, with Europe failing to put in place the

preconditions for a sustainable resumption of growth for the
foreseeable future. At best, the European economy would
“bounce along the bottom,” with no to very slow growth.
Clearly, the eurozone would not be an attractive place to invest under such circumstances. Another scenario would be
for frustration to boil over and for impatient politicians, disregarding purely economic costs and benefits, to pull the plug,
abandoning the single currency. The important point here is
that there is no such thing as the orderly dismantling of the
eurozone. Pulling the plug – one country or a collection deciding to abandon the euro – would provoke the mother of all
financial crises. There would then be an extended period of
turbulence and risk of serious losses. There would be no way
around it. Investors should consider themselves forewarned.
They should hope at all costs that this dire scenario is avoided.


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Feldstein, Martin (2010), “Let Greece Take a eurozone ‘Holiday’,” Financial
Times (16 February), http://www.ft.com/intl/cms/s/0/72214942-1b30-11df953f-00144feab49a.html#axzz2sTRS5lC8.

Allen, Franklin, Thosten Beck, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner (2011), Cross-Border Banking in Europe: Implications for
­Financial Stability and Macroeconomic Policies, London: Centre for Economic
Policy Research.

Folkerts-Landau, David and Peter Garber (1992), “The ECB: A Bank or a
­Monetary Policy Rule?” in Matthew Canzoneri, Vittorio Grilli and Paul Masson (eds), Establishing a Central Bank: Issues in Europe and Lessons from the US,
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Bayoumi, Tamim and Barry Eichengreen (1993), “Shocking Aspects of
­European Monetary Integration,” in Francisco Torres and Francesco Giavazzi
(eds), Adjustment and Growth in the European Monetary Union, Cambridge:
Cambridge University Press, pp.193-240.

Frankel, Jeffrey (2013), “Can the Euro’s Fiscal Compact Cut Deficit Bias?”
http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2013/02/06/canthe-euro%E2%80%99s-fiscal-compact-cut-deficit-bias/ (6 February).

Bayoumi, Tamim and Barry Eichengreen (1995), “Restraining Yourself: The
Implications of Fiscal Rules for Economic Stabilization,” IMF Staff Papers 42,
Bayoumi, Tamim and Paul Masson (1995), “Fiscal Flows in the United States
and Canada: Lessons for Monetary Union in Europe,” European Economic
­Review 39, pp.253-274.
Bernanke, Ben (2002), “Deflation: Making Sure ‘It’ Doesn’t Happen Here,”
­Remarks by Governor Ben S. Bernanke before the National Economists Club,
Washington, D.C. (21 November), http://www.federalreserve.gov/boardDocs/speeches/2002/20021121/default.htm .
Blanchard, Olivier and Francesco Giavazzi (2002), “Current Account Deficits in
the Euro Area: The End of the Feldstein-Horioka Puzzle?” Brookings Papers on
Economic Activity 33, pp.147-210.
Blanchard, Olivier and Lawrence Katz (1992), “Regional Evolutions,” Brookings
Papers on Economic Activity 23, pp.1-61.
Blanchard, Olivier and Daniel Leigh (2013), “Growth Forecast Errors and Fiscal
Multipliers,” American Economic Review 103, pp.117-120.
Bordo, Michael and Finn Kydland (1995), “The Gold Standard as a Rule: An
Essay in Exploration,” Explorations in Economic History 32, pp.423-464.
Brezzi, Monica and Mario Piancentini (2010), “Labour Mobility and Development Dynamics in OECD Regions,” unpublished manuscript, OECD (June).
Buchheit, Lee and Mitu Gulati (2000), “Exit Consents in Sovereign Bond
­Exchanges,” UCLA Law Review 48 (October).
Charlemagne (2014), “The Euro’s Hellhound,” Economist (1 February), http://
Ciccarone, Giuseppe (2013), “Geographical Labour Mobility in the Context of
the Crisis: Italy,” Birmingham, European Employment Observatory.
Committee on International Economic Policy and Reform (2012), Banks
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Sovereign Bankruptcy, Washington, D.C.: Brookings Institution for Committee
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“Growth, Convergence and EU Membership,” Working Paper no. 2005-62,
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“The eurozone Crisis: Phoenix Miracle or Lost Decade?” Journal of Macro­

Frankel, Jeffrey and Andrew Rose (1998), “The Endogeneity of the Optimum
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von Hagen (2010), “A European Mechanism for Sovereign Debt Crisis Resolution: A Proposal,” Bruegel Blueprint Series, Burssels: Bruegel.
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­Robert Mundell and Alexander Swoboda (eds), Monetary Problems of the
­International Economy, Chicago: University of Chicago Press, pp.41-60.
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unpublished manuscript, Graduate Institute for International Studies,
­Geneva (October).


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The reference is of course to Mundell (1961).


See McKinnon (1963) and Kenen (1969).


The Anglo-Saxon literature refers to “fiscal federalism” rather than “­fiscal
integration.” Fiscal federalism has a somewhat different meaning in
countries like Switzerland, where it refers to the high degree of autonomy that local jurisdictions possess in choosing the level and structure of
their tax and public expenditure systems. To limit confusion I refer here
to fiscal integration wherever possible.


And not anticipated by those of us who count ourselves among their
intellectual descendents, who are similarly not to be absolved of blame.


Although these were neglected as well – for an example, see Blanchard
and Giavazzi (2003).


As shown by Allen et al. (2011) and the Committee on International
Economic Policy and Reform (2012), most cross-border capital flows are
channeled through banks and are heavily procyclical.


In the short run, drawing a line under the crisis requires adequately
recapitalising the banks, so that they have sufficiently strong balance
sheets to support renewed lending to the nonbank private sector. (The
role of banking union is different; it is to prevent the behaviours that
bred the crisis and resulted in the current problem of inadequate capitalisation from recurring in the future.) Whether Europe successfully addresses this short-term problem will depend on the details of its Asset
Quality Review and Stress Tests.



The Banking Recovery and Resolution Directive adopted at the end of
2013 provides for bailing in bank creditors (in the amount of 8 percent
of total liabilities) to help defray the costs of bank resolution, but in systemic crises this will not be enough.
It is important to recognise that more often than not, bank resolution
in the United States occurs smoothly not because the Federal Deposit
Insurance Corporation is generously endowed with financial resources
but because there are no restrictions on the acquisition and merger of
banks across state borders. The most recent US bank failure at the time
of writing was that of Syringa Bank of Boise, Idaho, with USD 153 million, which was quickly acquired by Sunwest Bank of Irvine, California,
following the injection of USD 4.5 million by the FDIC. European politicians, sensitive to the fact that banks are regarded as national champions, remain reluctant to contemplate analogous cross-border mergers.
Clearly, it would help if Europe had a single market in bank acquisitions
to complement its single currency (Eichengreen, Jung, Moch and Mody

10     A good introduction to what has and has not been done is IMF (2013).

13     The Court then asked the European Court of Justice to look into the
conditionality aspect of OMT, whether there had to be a specific
gap between the primary market issue date and secondary market
­purchase price before securities could be purchased, and whether the
­programme, in order to be consistent with European law, had to be subject to a ceiling on purchases. A ruling should be forthcoming from the
­European Court within a couple of years. In the meantime the uncertainty will linger.
14     See Charlemagne (2014).
15     The classic statement of the Bernanke doctrine is Bernanke (2002).
16     If Lithuania joins, as expected, the maximum size of the Board permitted
by the bank’s statute will have been achieved, and one country ­after
­another, in turn, will then rotate off the Board. This will prevent the
Board from growing even more unwieldy without, however, solving the
existing problem.
17     See Blanchard and Katz (1992).
18     See the discussion in Eichengreen, Jung, Moch and (2013) for details.
19     See Molloy, Smith and Wozniak (2013) and also Dao, Furceri and Loungani (2014).
20     See Naumann (2013).
21     See Bayoumi and Masson (1995).
22     See Blanchard and Leigh (2013).
23     In the manner of countries like Chile.
24     See Sinn (2013).
25     Syriza, the left-wing party that is poised to head the next Greek coalition, has already signaled its intention of calling for such a conference.
26     One imagines that Professor Sinn is inspired by memories of the Dawes
Plan Conference that restructured German debts in 1924 and the
­London Conference that restructured the debts of West Germany in
1953; the difference, of course, is that these were purely intergovernmental debts, limiting the parties at the table.
27     For details see Buchheit and Gulati (2000).
28     The IMF made the case in an April 2013 paper (IMF 2013), as did the
independent Committee on International Economic Policy and Reform (CIEPR 2013). Earlier ideas along similar lines are Giaviti, Krueger,
Pisani-Ferry, Sapir and von Hagen (2010), who prefer a mechanism that
vests more discretion in the hands of the decision makers (a special
chamber of the European Court of Justice) but would similarly make the
restructuring of unsustainable debts a precondition for the extension of
emergency assistance.
29     See Bordo and Kydland (1995).

11     See Folkerts-Landau and Garber (1992).
12     Officially, OMT was aimed exclusively at “safeguarding an appropriate
monetary policy transmission and the singleness of monetary policy,”
but the larger objectives are clear.

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