[No.139] European Monetary Integration and Sovereign Debt Crisis

Abstract

The aim of this paper is to have a better understanding of the reasons behind the difficulties that the euro area faced, and the problems that led to the outbreak of the sovereign debt crisis in 2010. The paper first examines the extent to which the euro area was an optimal currency area (OCA). After finding that there were too much inflexibility and rigidity to be an OCA as a whole, it goes on to discuss the reasons for not being one in spite of the fact that euro area countries were chosen on the basis of the Maastricht convergence criteria. It also discusses the existence, among the euro area countries, of ex-post pressures towards OCA, provided by market forces arising from improvement in economic opportunities, and by implementation of policies that aimed to introduce more flexibility into the euro area. Another issue that the paper focuses is the reason for the absence of pressure from the financial markets that should have provided discipline to countries with fiscal problems. Since low interest rates were a common phenomenon in industrial countries, it needs to be discussed in the context of a global change in financial structure. A number of hypotheses that have been proposed to explain the phenomenon, including the global banking glut hypothesis, are taken up and discussed. It concludes by noting the importance of a strong political will to implement structural reform even in a favorable macroeconomic environment.