Can the Eurozone Survive?
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R E V : J U L Y 3 , XXXXXXXXXX
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Senior Lecturer Dante Roscini and Research Associate Jonathan Schlefer prepared the original version of this case, “Can the Eurozone Survive,”
HBS No XXXXXXXXXX, which is being replaced by this version prepared by the same authors. This case was developed from published sources. HBS
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D A N T E R O S C I N I
J O N A T H A N S C H L E F E R
Can the Eurozone Survive?
In November 2009 a newly elected Greek government revealed that previous data had gravely
understated the budget deficit. Greece sank into crisis as yields on its bonds sailed steadily upward—
past 30% for ten-year maturities.1 Despite cutting its primary deficit 4.2% per year from 2009 through
2011, arguably the most severe reduction in the developed world in recent decades, Greece effectively
went bankrupt, and in early 2012 its lenders were forced to take a €100 billion loss on its debt.2
Though Greece produced just 2.5% of Eurozone GDP, its crisis ignited crises across southern
Europe—now flaring, now subsiding, now flaring again—amid fears of the euro’s collapse.3
European leaders repeatedly vowed to do “whatever it takes” to save the euro, the Financial Times
lamented, but “just as often their subsequent actions, or lack of them, have belied these fine words.”4
In early 2012, things started looking up. After the European Union (EU) had promised a
permanent €500 billion fund to lend to threatened governments and proposed a tough fiscal pact, the
European Central Bank (ECB) loosed a “wall of money”—€2 trillion of loans to national banks in
hopes that they would, in turn, lend to governments and industry.
But by summer, euro optimism was sinking again. Amid widespread talk of “Grexit,” a Greek exit
from the euro, Citi’s chief economist went so far as to put a specific figure on the speculation. He said
the probability that Grexit would occur within 12 to 18 months was 90%.5 Meanwhile, yields on 10-
year Spanish bonds reached 7.6% and those on Italian bonds 6.6%—levels that might well lead both
nations into debt traps like Greece.6
Then, on the eve of the summer Olympics, ECB President Mario Draghi, reiterating a phrase that
had been heard so often before, announced, “Within our mandate, the ECB is ready to do whatever it
takes to preserve the euro. And believe me, it will be enough.”7 He seemingly intended to buy large
quantities of bonds of troubled governments. If that was his idea, no one was sure he would get it
past adamant opposition from the powerful German central bank, the Bundesbank. Still, yields on
Spanish and Italian bonds dropped significantly, and European stocks surged 4% that day.
Why did contagion from tiny Greece so rapidly infect the entire Eurozone? Would the accretion of
measures promised by the European Union (EU) and the ECB, in coordination with the International
Monetary Fund (IMF), finally be adequate to staunch the crisis? And would the euro survive?
For the exclusive use of G. Ca
ena, 2021.
This document is authorized for use only by Graciano Ca
ena in Competition in the Global Economy taught by NOEL MAURER, George Washington University from Jan 2021 to Jul 2021.
XXXXXXXXXXCan the Eurozone Survive?
2
Creating the Euro
The international financial order negotiated in Bretton Woods, New Hampshire, in 1944, fixing the
dollar against gold and other cu
encies against the dollar while allowing devaluations in exceptional
circumstances, proved workable through the 1960s. But it fell apart when the United States devalued
the dollar in 1971 and finally abandoned any fixed exchange rate in 1973.
The resulting exchange-rate volatility, two oil crises, and other troubles in the 1970s led to
elatively high and e
atic inflation. Exchange-rate volatility posed particular problems for nations of
the European Community (EC), predecessor of the European Union, as EC members lowered mutual
trade ba
iers. For example, when cu
encies fluctuate, firms face more uncertainty about what
imported input materials will cost them or what their products will sell for a
oad. As a result, they
are likely to reduce investment.8
In 1979 the EC tried to stabilize cu
encies in a system called the Exchange Rate Mechanism
(ERM). French and Italian politicians hoped the ERM would lower their rates of inflation by tying
their cu
encies to the German mark.9 German Chancellor Helmut Schmidt had an essentially
political goal: “binding West Germany closer to Western Europe.”10 Despite the ERM, exchange-rates
continued to fluctuate in the early 1980s but began to settle down late in the decade.
After the Single European Act, entering into force in 1986, called for eliminating all ba
iers to
trade, financial flows, and migration within the EC, many saw a single cu
ency as the natural next
step. Some argued that makeshift bands like the ERM were bound to fall apart sooner or later; the
only viable systems, in this view, were fully flexible exchange rates or a single cu
ency.11
The EC planned a single cu
ency. Again, the goals were political as much as economic. Having
fought repeated wars with Germany, France feared its unification after the Berlin Wall fell in 1989.
French President François Mitte
and saw a common cu
ency as cementing a more peaceful
Germany and agreed to back the united Germany’s entry into the EC (in effect, it was a new country)
if German Chancellor Helmut Kohl backed a common cu
ency.12 Kohl believed a common cu
ency
would provide a core of European stability as former members of the Eastern Bloc joined it.13 And
even he said it would
ing peace by “containing a potentially dangerous Germany within Europe.”14
Not everyone agreed. The U.S. economist Martin Feldstein wrote, “Germany's assertion that it needs
to be contained in a larger European political entity is itself a warning. Would such a structure
contain Germany, or tempt it to exercise hegemonic leadership?”15
The so-called Maastricht Treaty forming the European Union (EU) and laying the road to
monetary union was signed in 1992. That very year, the ERM came under attack again. Finland,
Sweden, and Norway stopped trying to peg their cu
encies, while Spain, Portugal, and Ireland had
to devalue, Italy was forced to let the lira float, and the British pound crashed. But by July 1, 1998,
eleven states were deemed to have met the “convergence” criteria for adopting the single cu
ency,
the euro: among other things, maintaining fiscal deficits under 3% of GDP and limiting government
debt to 60% of GDP. They adopted the euro on January 1, 1999.
In fact, six of the eleven original Eurozone members did not meet the debt limits (Exhibits 1 and
2). However, a weighted majority vote of member governments had the actual power to decide
which nations adopted the euro, and political criteria prevailed.16 A Stability and Growth Pact (SGP)
equiring members that violated debt and deficit limits to be monitored under an “excessive deficit
procedure” was often ignored. In the first decade of the euro, Germany violated the debt limits every
year but one, and France violated them six years. Perhaps worst, in 2003, when Germany and France
exceeded the deficit limits, the European Commission, the EU’s administrative body, called for an
For the exclusive use of G. Ca
ena, 2021.
This document is authorized for use only by Graciano Ca
ena in Competition in the Global Economy taught by NOEL MAURER, George Washington University from Jan 2021 to Jul 2021.
Can the Eurozone Survive? XXXXXXXXXX
3
excessive deficit procedure, but the heads of state meeting in the Council of Ministers, where
Germany and France held heavily weighted votes,
ushed the commission aside.17 This was a
turning point, says Philip Maystadt, former Belgian finance minister.18 Henceforth, other finance
ministers concluded they would not have to pay much attention to the SGP either.
The Euro: More Complicated Than It Looks
The euro was an unprecedented experiment. No other major nation lacked its own cu
ency.19 The
Treaty on European Union, deeply held beliefs, and the structure of national economies would
profoundly influence this experiment. These factors help explain why the Eurozone, with a 6% of
GDP deficit and 85% of GDP debt in 2010, was threatened with sovereign crises, while the United
States, with substantially higher deficits and debt, was not (Exhibits 1 and 2). Similarly, Spain, a
Eurozone member with a 9% of GDP deficit and 61% of GDP debt, entered into crisis in 2010, while
Britain, still on the pound sterling, with a 10% of GDP deficit and 80% of GDP debt, did not.
Article 125 of the Treaty on European Union, the “no-bailout clause,” fo
ade the European Union
or national governments from assuming the debt of other member governments.20 After a
government bo
owed 60% of GDP, the treaty demanded budget cuts and tax increases, even if they
deepened a recession. “If you live beyond your means, then you can repair your balance sheet only if
your consumption goes down,” said Jörg Krämer, chief economist of Commerzbank in Frankfurt.21
A driving force behind debt and deficit limits, particularly after the crisis struck, was German
inflationary fear. Hyperinflation—inflation so high that
ead prices change literally by the hour and
life savings evaporate—had devastated Germany after World War I and contributed to the downfall
of its first democracy, the Weimar Republic. Memories of that hyperinflation permeated the German
mentality as only the most cataclysmic national experiences can.
Most advanced nations such as the United