Extract

The European debt crisis confronts us with a number of questions. What went wrong? Why were we so late in spotting what went wrong? What can be done about it? The central thesis of this contribution is that the rules governing the economic and monetary union (EMU) focused too much on fiscal positions and excessive deficits. However, fiscal profligacy was not the root cause of the crisis, but mainly a manifest of much deeper-rooted macroeconomic and financial imbalances, such as asset price bubbles and loss of competitiveness. In the future design of EMU, these underlying causes will have to be addressed. Before the start of EMU, several economists doubted whether rules for national governments were necessary at all (for an overview of the discussion, see Eichengreen and Wyplosz, 1998). Some of them were convinced that financial markets would enforce policy discipline. Markets were expected to restrain profligate governments by charging them higher interest rates and, thus, forcing them to change their ways.