Maastricht and the Crisis in Europe Overview

Written by Sandy Williams

The European Union was formed in 1992 with the signing of the Maastricht Treaty on European Union (TEU). In an effort to instill fiscal discipline and encourage trade and free flow of labor and capital without giving up sovereignty, member countries would participate in a monetary union while remaining fiscally independent. The caveat was countries would be expected to respect limits on the size of public debt and deficits and could not expect a “bailout” if national finances spiraled out of control. Market discipline reinforced by the “no bailout” clause was supposed to ensure member countries stayed in compliance with the fiscal rules.

That was the idea, but the practice was different from theory according to Reza Moghadam, director, European Department of IMF, in her presentation “Maastricht and the Crisis in Europe: Where We’ve Been and What We’ve Learned” delivered at the ECB/NBB Conference in Brussels on February 12, 2014.

Countries that were vulnerable for high debt, like Greece and Italy, joined the EU. Other countries fell in and out of compliance without sanction. By 2011, there was doubt whether the EU would be able to survive.

In 2012, the European Stability Mechanism (ESM) was established to provide financial assistance to EU member countries in financial difficulty. The ESM had a maximum lending capacity of €500 billion and acknowledged that the “no bailout” policy wasn’t working.

Those EU members with vulnerable private sector balance sheet turned out to be the ones who lagged behind in recovery post-crisis unable to compete with other member countries.

For example, the higher the pre-crisis leverage of a country’s household sector, the lower the growth in consumption following the crisis,” said Moghadam. “The story for corporates is similar, where there is a striking negative correlation between corporate leverage and future investment growth. And for banks, we know that those with high pre-crisis leverage have had to shrink their balance sheets.”

Moghadam also notes that “private imbalances can eventually end up as public sector imbalances” either through direct bailout of banking systems or prolonged declines in output.

With financial regulations inconsistent across member countries and the introduction of a single currency when the financial crisis hit “the result was pervasive and persistent financial market fragmentation in the euro area.”

Policy Progress
The crisis exposed weaknesses in the Maastricht treaty as well as the European Monetary Union (EMU). Since that time, the EU governance has been strengthened through the addition of the Fiscal Compact and a move has been made toward a banking union. Moghadam says despite improvements “financial market fragmentation persists and the recovery is weak and fragile.”

Moghadam provides several suggestions to improve stability in the EU:

1) Clear rules for bail-ins, harmonization of insolvency regimes at the national level, and a Single Resolution Mechanism with centralized power to resolve and share burdens in the financial sector.

2) Improve transparency and confidence with the SRM

3) Address shortcomings in the Macroeconomic Imbalances Procedure: emphasis on emerging competitiveness gaps and strong corrective actions before imbalances occur

4) Broader capital markets to diversify funding for firms and reduce reliance on the banking sector.

5) A shared approach with some centralized fiscal policy to balance fiscal stances during severe recessions and during expansions.

6) Growth enhancing reforms including product market reforms, greater labor mobility and protection of workers with unemployment benefits and retraining options.

To read “Maastricht and the Crisis in Europe: Where We’ve Been and What We’ve Learned” by Reza Moghadam in its entirety, click here.

About the IMF: The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world.

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