The euro area crisis rst surfaced in 2009 when Portugal, Ireland, Greece and Spain

slipped into recession with exceedingly high budget decits. The crisis deepened
further in 2010 with credit rating agencies downgrading the sovereigns and banks in
the peripheral Europe. This signicantly dented con dence, even threatening the
very existence of the euro. Consequently, the risks to the global economy rose due
to interconnectedness of nancial markets and increasing dependence of the EMEs
on exports and capital inflows.
The problems in the euro area are largely structural in nature and existed even prior
to the crisis. In the years preceding the crisis, the EU became divided between
countries with positive trade balances and sound budgets the core and those
with growing budget decits and external decits nanced by private credit flows
increasingly sourced from the rst group of countries for unproductive spending
the periphery. With the onset of global nancial crisis in the US in 2008, the external
decits, budget decits and levels of public debt of the countries in the second
group largely became unsustainable once they were no longer nanced by the rest
of the EU. In late 2009 Greece admitted that its scal decit was understated(12.7
%of GDP as against 3.7 %stated earlier). This was in violation of the Maaastricht
Treaty which required.
A monetary union without a fiscal union:
The creation of the Euro zone had an inherent contradiction of being a monetary union but not a
fiscal union. The introduction of the euro in 1999 explicitly prevented the ECB or any national central
bank from financing government deficits. As a consequence the central bank has no power to
monetize deficits. The above arrangement put a premium on each country to follow a similar fiscal
path, but, without a common treasury to enforce it. The spending authorities remained national and
subject to their own political compulsions. So long as growth across the region was strong, the fiscal
capacity was not a source of worry. In such an arrangement the possibility of fiscal free riding is
present as seen from the current episode for Greece. Given the differences in the structure and
competitiveness of the peripheral economies, it is not surprising that their compliance to thegrowth
and stability pact was often in breach. And this weakness got further exposed in the after math of the
global crisis due to the operation of fiscal stabilizers,
a rise in the
unemployment compensation
and
a fall in
tax revenues. The option of improving the competiveness of the economy
through
exchange rate
depreciation was not available from the very inception of the monetary
union.
The EU budget is only 1 % of the EU GDP and not an effective instrument for fiscal
stabilization.
Had
there
been a fiscal union
,
with a system

horizontal t
ransfer and
controls, the deficit and debt ratio of the peripheral economies may have been contained.
But in the present case, a
fiscal crisis
in the periphery
automatically translated into zonal
monetary
and financial
crisis with
t
he central monetary auth
ority not empowered to act
as the lender of last resort.
This brings home an important lesson that setting up pacts and codes of conduct by
themselves are not enough, unless, the underlying incentives to adhere to them are also
reasonably well aligned. I
t has also been argued that the fiscal criteria proved difficult to
enforce but generated a false assurance that as long as there was a criteria, all was well.
They failed to see that other structural problems were far more dangerous to economic
stability
of the euro zone that included the lack of control and regulation over national
financial institutions

The Maastricht Convergence Criteria and the Stability

and Growth Pact
The Maastricht Treaty requires EU countries to satisfy several macroeconomic
conver-gence criteria prior to admission to EMU. Among these criteria are:
1. The countrys inflation rate in the year before admission must be no more than
1.5 percent above the average rate of the three EU member states with the lowest
inflation.
2. The country must have maintained a stable exchange rate within the ERM
without
devaluing on its own initiative.
3. The country must have a public-sector decit no higher than 3 percent of its GDP
(except in exceptional and temporary circumstances).
4. The country must have a public debt that is below or approaching a reference
level of
60 percent of its GDP.

The government budget decit stood at 12.7 percent

of GDP, more than double the numbers announced by
the previous government. Apparently the previous
government had been misreporting its economic
statistics for years, and the public debt actually
amounted to more than 100 percent of GDP
V
arying productivity
and
Structural differences
: Within the euro zone
,
there is
substantial variation in terms of productivity. Th
e peripheral economies have lower
labor
productivity compared to
Germany (taken as a bench mark of 100) which clearly stands
out in terms of unit labour costs.
First, a large part of the
fragile scal position in these economies is attributable
to expenditure on entitlements due to an ageing
population without commensurate increase in revenues
and lack of growth-enhancing structural reforms. In
this process, the public sector structure has become
bloated. Second, due to low domestic saving rate, public
debt had to be nanced through borrowings resulting
in widening of current account de cit and a growing
external debt. While the membership of the euro area
gave a false sense of comfort to the periphery countries,
the intra-euro area nancial imbalance remained
severe.