Although the euro area has come a long way in terms of institutional strengthening and enhancing financial resilience future shocks since the financial of the late 2000s and early 2010, significant institutional weakness remain. The single European currency, the euro, was created in 1999-2002. In the first decade of its existence, it contributed to economic and monetary convergence among its members, as capital flowed from the low-interest core to the high-interest periphery, leading to an economic and financial boom as well as a gradual build-up of financial vulnerabilities in the context of overborrowing by government and excessive lending to the real estate sector by banks. The euro area debt crisis was triggered in in late 2009 when the Greek government was forced to acknowledge that it had systematically underreported its fiscal deficit. The ensuing crisis, which risked forcing significant losses on euro area banks and cast doubt on the creditworthiness of highly indebted governments, almost led to the financial and institutional collapse of the single currency. The single currency came about as a political agreement between France and Germany, largely reflecting German preferences. As such, Economic and Monetary Union (EMU) was established as an incomplete monetary union. Among other things, it included a no-bail out provision meant to force members to pursue fiscally prudent policies and prohibit the central bank from providing monetary financing to member-states in view of preserving monetary stability. The Maastricht criteria and later the Stability and Growth Pact sought to obligate members to maintain low government debt and small fiscal deficits, but the accompanying enforcement mechanisms were too weak. The regime lacked the instruments to backstop governments and banking system in financial trouble, beyond national level, to prevent financial contagion in the euro area.
> Starting in 2010, the euro area cobbled together in a less and after 2012 in a more systematic manner financial rescue programs to contain financial contagion and prevent a broader financial breakdown of the euro area. Greece received financial bailouts in 2010 and 2012, Ireland in 2010, Portugal in 2011 and Cyprus in 2013.
> Banking crises in Spain, Ireland and Cyprus led the respective governments to request financial bailouts, which, in the case of Cyprus, was accompanied by a bail-in of bank depositors. The Greek government restructured its debt in 2012 and has engaged in several voluntary debt exchanges since then.
In the face of the quasi-existential debt crisis, the euro area has seen major institutional reform, which have helped make the single currency more resilient. The financial crisis forced the euro area into wide-ranging institutional reform to prevent a complete financial breakdown, manage the risk of a breakup of the single currency, reestablish economic stability and prevent future financial crises. The existence of a “no bail out clause” (Art. 125 of TFEU) made the single currency vulnerable to destabilizing financial contagion. Typically, central banks act as a lender-of-last-resort, not just to the banking system but also to the sovereign. In the euro area, the European Central Bank was prohibited from playing this role. Once signs of financial distress and investors began analyzing the various cross-cutting financial linkages, from Greek government debt to European and Cypriot banks as well as from weakened banking systems to generally financially solid sovereigns, like in Ireland and Spain, the euro area was forced to address the immediate consequences of the crisis and implement broader reforms to reduce future crisis risks. Despite establishing a financial rescue mechanism, it was the ECB with its notionally unlimited financial resources and its commitment to do “whatever it takes” that helped stabilize the euro area. In addition to establishing a bail-out mechanism implicitly if conditionally backed by the European Central Bank, the euro area reformed its fiscal regime and made some, if limited progress toward banking union in an attempt to prevent future sovereign crises to spill over into the banking sector as well as minimize the risks of a banking crisis causing sovereign financial distress (so-called sovereign-bank nexus).
> During the initial emergency in 2010, the euro area members were forced to provide financial support to prevent broader financial contagion and the systemic destabilization of the euro area. This took place, first, in the guise of the European Financial Stability Mechanism (EFSF) and the European Financial Stability Mechanism (ESFM). Due to their limited size, both funds were replaced by the newly established only euro area member funded European Stability Mechanism (ESM) in 2021. The ESM today effectively functions as a euro area IMF, providing financial resources to distressed members in exchange for economic adjustment and reform.
> The ECB created new instruments to stabilize markets. Through the Securities Markets Programme (SMP) it sought to contain long-term interest rates in financially weaker countries. In 2012, it established an instrument called Outright Monetary Transactions (OMT), which promised to backstop sovereign unconditionally under certain conditions, such strict policy conditionality under an EFSF/ ESM programme. In 2022, the ECB created a so-called Transmission Protection Instrument (TPI) in 2022, which officially is meant to ensure the smooth transmission of monetary policy but effectively allows the ECB to contain the interest rates spreads of financially weaker member countries relative to the stronger ones by allowing it to purchases unlimited amounts of medium- and long-term debt securities, again provided the country is pursuing a sound fiscal policy, does not suffer from macroeconomic imbalances and is compliant with EU fiscal rules. In addition, the ECB created a Public Sector Purchase Programme (PSPP) as well as other programmes that allow it to make large-scale purchases of non-sovereign financial assets in the secondary market in the context of its quantitative easing policy. At the beginning of the COVID-19 pandemic, it also created a Public Emergency Purchase Programme (PEPP), worth EUR 1,350 billion. Central bank purchases of sovereign debt help keep down borrowing costs and are seen by purists as monetary financing of government debt.
> The euro area members also implemented several reforms of their fiscal regime. In 2011, it introduced the so-called “six pack” of regulation aimed at tightening the rules of the Stability and Growth Act. In 2012, the fiscal compact replaced by and rolled into the Stability and Growth Pact and further tightened the fiscal regime governing national financial policies in terms of restrictions and enforcement of rules, adjustment requirements and transparency. The compact subjects member countries’ fiscal policies to European Commission surveillance, commits countries to a mandatory balanced budget rule, strengthens the excess deficit procedure and requires convergence toward medium-term objectives, among other provisions. The compact was updated in 2024 to make them less complex and hence less complicated to enforce.
> The euro area also took steps to limit the risk of systemic banking crises. It established a Single Supervisory Mechanism (SSM, 2014), which gives the European Central Bank supervisory powers over large euro area (and selected EU) banks. (Smaller banks largely remain under the supervision of national authorities.) It created a Single Resolution Mechanism (SRM) to allow for the orderly resolution of banks. The Single Resolution Fund (SRF) is meant to help resolve failing banks in case bail-ins are not viable and prevent disorderly bankruptcies in the banking sector through bailing in of creditors or an orderly winding up.. The SRF is funded by banks and is meant to cover 1% of all euro area deposits (or EUR 55 billion OR EUR 78 billion in July 2023). The euro area failed to make progress on the third pillar, namely a European Deposit Insurance Scheme (EDIS, 2015, not adopted) to limit the risks and costs to governments of bank failures. A recent reform, currently in the process of being approved, is seeking to deploy the ESM as a backstop to SRF through revolving credit line.
Although the euro area proved resilient in face of COVID-19 pandemic and Ukraine war related shocks, the present institutional architecture continues to make it more vulnerable to severe shocks than, for example, the dollar. The euro zone architecture is incomparable more robust than 15 years ago, but it continues to be characterized by important weaknesses, particularly compared to countries with a more centralized fiscal authority and a national central bank. First, while a financial rescue mechanism makes the system more resilient, their funding capacity is limited. This is why the ECB’s OMT is an indispensable element of the euro area’s financial architecture, as it provides the financial firepower to credibly backstop even larger member governments. Second, the financial firepower of the SRM is also quite limited. Again, while the ESM provides additional financing under certain conditions, the financial capacity, accounting for just 1% of euro area banking deposits is small, particularly if there is no additional explicit or implicitly actor able and willing to backstop the system in case of a severe crisis. Many national banking systems remain vulnerable given their government’s limited ability to backstop to the system and no common euro area wide deposit insurance, which will exacerbate bank runs in moment of crisis, as local depositors will move their money to euro area countries not at risk of default of currency denomination. Since the end of the euro area debt crisis in in the mid-2010, euro area governments have benefitted from low nominal interest rates and extensive central bank purchases of their sovereign debt. While they have thus far weather higher policy rates, it remains to be seen how well they will cope with higher interest rates as well as wider spreads. The medium- and long-term financial outlook will also prove challenging in view of the need to increase spending on defense, the green transition and social welfare due to population aging. This will be particularly challenging for countries with low economic growth. In the face of these pressure, the domestic consensus in favor of prudent fiscal policies and compliance with euro area fiscal rules may erode and lead to increased conflict with national-level fiscal priorities and euro area level restrictions. This in itself has the potential to upset markets and lead investors to charge higher interest rates, thus exacerbating the financial outlook of financially challanged countries.
> Euro area government debt has increased significantly in euro terms, hence relative to the financing capacity of the ESM. Italian and French government debt amounted to around EUR 3 trillion, respectively, or 140% of GDP and 110% of GDP. ESM total lending capacity amounts to a mere EUR 500-700 billion. Domestic credit to the private sector, a proxy for the banking sectors’ non-sovereign lending as well as a sovereign contingent liabilities in the case of a banking sector bail-out, stood at 70% and 120% of GDP, respectively. EUR 500 billion ain’t a lot of money.
> The recently created NextGenerationEU or European Union Recovery Instrument, adopted in 2020, provides for common EU funding financed by EU-level resources. But the financially stronger, net payer governments have made it clear that it will remain a one-off, it will run from 2021-2027 and provide a mere EUR 750 billion to support post-pandemic investment and reform. However, the financial challenges of many of the weaker euro area members are much larger in financial scope and time horizon. The new instrument is drop in the bucket as far as the longer-term fiscal challenges are concerned.
The politics of euro area reform and crisis-proofing will remain contentious and significantly increased direct or indirect resource transfers and risk sharing will remain unlikely in the next few years. The reforms pit low-debt “creditor” countries in the North against high-debt “debtor” countries in the South, with France (as a country with large government debt) leaning towards the latter. Reform will be slow, absent another major, systemic crisis. Although all member countries have an interest in increasing the resilience of the euro area to shocks, they disagree as to how to distribute the actual and potential costs of the reforms. Reforms that risk creating a so-called “transfer union” by enshrining the possibility of a permanent resource transfer is not attractive to creditors, financially, economically or politically. The creditor countries retain veto power of any such reform. This is also why any resource transfer and risk sharing is limited and typically conditional, whether this relates to emergency lending, banking resolution or banking union. Financially more vulnerable countries, namely countries with large government debt and a banking sector owning large amounts of national government debt, is simply not in a position to make a major contribution to risk sharing. The fiscal conservative countries will continue to resist reform aimed at substantially greater risk sharing or resource transfers, while the debtor countries will continue to oppose institutional reform that transfers the costs of financial distress, whether in terms of macroeconomic adjustment, sovereign debt restructuring or banking sector insolvencies, to financially weaker countries. Absent another major shock, the euro area will likely prove sufficiently resilient in the next few years so as not to require important reform. At the same time, the euro are is unlikely to suffer any defections due to popular opposition in member countries or adverse legal rulings that undermine key elements of the current financial-institutional architecture. The euro remains very popular in virtually all euro area countries, and legal challenges brought against the new financial architecture have been largely, if not completely defeated by national constitutional or European courts.
> The interests of fiscally conservative, largely Northern European euro area members, and less financially disciplined countries in the South continue to diverge, making it difficult to make progress in terms of euro area institutional reform. The former broadly oppose significant resource transfers and direct or indirect risks sharing. Government debt exceeded a 100% of GDP in Greece, Italy, France, Spain, Belgium and Portugal. It was below 70% of GDP in Germany, the Netherlands, Ireland and the Baltic countries.
> Virtually all euro area government face significant long-term fiscal challenges caused by a combination of aging populations and welfare systems, including pension and health spending. In addition, increased spending on the green transition and defense will also put upward pressure on fiscal deficits and, in most cases, government debt ratios. Significant fiscal reform necessary will prove politically controversial. It will make it unlikely for significant intra-euro redistribution to take place. Ergo, no Hamiltonian moment.
> The euro remains popular. Support is high in all euro area member countries, but much lower in in virtually all non-euro area EU members. Popular opinion can change quickly if euro area membership were to be associated again with economic conditionality and financial crises. Although the economics of common currency areas are complicated, the median voter’s intuition that the benefits of membership in the single market and the single currency are significant and that the costs of exiting are very large is sound. The economic reality is that exiting the euro area would prove a financial disaster and would likely force the country out of the single market, even if no legal mechanism to force it to do so exists. This has forced populist parties to back away from calls to exit the single currency to make themselves more electable, thus reducing the risk of a politically driven euro exit.