CREATING A EUROZONE THAT WORKS - A WAY FORWARD - Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz

Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz (2016)



The euro can and should be saved—but not at any cost. Not at the costs of the recessions and depressions that have afflicted the eurozone, the high unemployment, the ruined lives, the destroyed aspirations. It doesn’t have to be this way. One can create a eurozone that works, that promotes prosperity and advances the cause of European integration.

The halfway house in which Europe finds itself is unsustainable: there either has to be “more Europe” or “less”; there has to be either more economic and political integration or a dissolution of the eurozone in its current form.

Those who originally promoted the euro realized that in its original stage, it was incomplete, and that more would have to be done. A successful euro required—and would lead to—“more Europe.” And more has been done. But what has been done so far is not nearly enough. What is required is not beyond the grasp of Europe—most of what is entailed has already been widely recognized. But it requires “more Europe” than the existing arrangement, and certainly “more Europe” than those who say that the eurozone is not a transfer union are willing to countenance.

The reforms in structure and policy that I describe will make the kinds of crises that have become a regular feature of the eurozone less frequent and less severe; but there still may be crises. I argue that a quite different set of emergency policies would be of benefit to the eurozone as a whole, but especially to the crisis countries. The depressions that have marked the euro crisis, with their long lasting effects, are avoidable.


Reforms of the structure of the eurozone itself should aim at an economic system that can simultaneously achieve full employment and robust growth in each of the member countries with sustainable current account deficits in the absence of flexible exchange rates and independent monetary policies. There needs to be a fundamental commitment of the eurozone to maintain the economies at full employment. Markets do not on their own maintain full employment, and markets on their own are not in general stable. In the absence of government intervention, there can be persistent unemployment and high instability.

Most critics of the euro crisis policies have focused on austerity, and rightly so. But without appropriate reforms in the structure of the eurozone—the institutions, rules, and regulations that govern it—restoring the countries to full employment will lead to unmanageable current account deficits. We saw how the eurozone’s current structure leads to divergence and actually creates current account deficits and crises. The eurozone needs to be reformed so that all countries within the eurozone can attain and maintain full employment. The current eurozone structure does not allow this. As we saw in the previous chapter, while the programs that have been imposed on the crisis countries are intended to eventually lead the country back to full employment, the path is extraordinarily costly with uncertain success. What is certain is that these programs will lower the crisis countries’ potential growth for years to come. It is also certain that these programs have other effects, such as increasing divisiveness within and between countries and giving rise to unpalatable political dynamics.

Six structural changes—changes in the basic rules governing the eurozone and their shared economic frameworks—are essential.


This reform is one on which the European leaders already agree. A common banking system—a banking union—entails more than common supervision; it entails common deposit insurance and common procedures for what should be done with banks that cannot meet their obligations (called common resolution).1 Of these three, the most important is a common deposit insurance fund. Without it, money will flow from the banking system of “weak” countries to the banks in strong countries, weakening further those already having problems. But without a common regulatory system, there is the worry that a system with a common deposit insurance scheme could be open to abuse. But, as I explain below, a common regulatory system has to be well designed, so that it can encourage expansion in those countries that need it and constrain lending in overheated economies. Later, we will explain how this can be done.

Without such flexibility, broadening mandates and instruments, a common regulatory framework will act as an automatic destabilizer— that is, when the economy is weak, it makes the economy even weaker. Indeed, chapter 5 showed that under the current system, the private austerity arising from the contraction of bank lending was a key contributor to the depressions in the crisis countries. But inflexible implementation of banking regulations would exacerbate the already present downturn: In any economic downturn, there is an increase in nonperforming loans (defaults). If regulators respond rigidly,2 banks will be forced to contract lending, and that will exacerbate the economic downturn. While rigid enforcement of standards makes sense for a bank in isolation, when weaknesses are a reflection of an economic downturn, it’s counterproductive: the economic slowdown arising from decreased lending will lead to even more defaults, in a downward vicious spiral.3

The incongruence between the pace of markets and that of politics presents a problem for the euro’s survival. Many European leaders recognize that eventually a single banking framework, with common regulations, deposit insurance, and resolution, will be necessary. But others argue that such a dramatic reform must be done carefully, in a step-by-step process. First, there must be common regulations, and when the regulatory system has been “proven,” Europe can go on to the next stage(s).4 Were there not an ongoing crisis, such an argument would have merit. But those with capital in, say, the Spanish banks will not wait: the benefits of waiting are nil, the risks are substantial. And so, while European leaders dither, the banking system will be weakened, and with the weakening of the banking system, there will be a weakening of the economies.5 And there can be strong effects: once the capital has left the country, once the banking system has been weakened, it may take a long time to restore the banking system and the country to health.


Just as creating a banking union is necessary if there is not to be divergent and destabilizing movements in capital, some form of mutualization of debt is necessary if there is not to be divergent movements in labor. Place-based debt makes little sense in a world in which individuals are mobile; individuals can simply walk away from debts incurred by their parents or by profligate politicians or by misguided decisions of the ECB. The movements in population are not only destabilizing, they are inefficient—undermining the very rationale for free mobility of labor.

Mutualization of debt could be accomplished through a number of institutional mechanisms, such as having the ECB issue a Eurobond underwritten by the eurozone as a whole with the revenues on-lent to different eurozone countries. There are already proposals on how to design such a system, in a way that won’t lead to excessive borrowing.6 The amount of mutualized debt could be limited, with safety valves for debt associated with cyclical fluctuations, recognizing that when a country goes into a recession it may be desirable to run a large deficit. The funds coming in from the new debt issues could be spent only on investments in, for example, infrastructure or education. There could be a requirement, too, that, except when the economy is in recession, any increase in debt over a certain level be subject to a referendum within the country.

The position of some in Europe against such mutualization—claiming that Europe is not a transfer union—is wrong on two counts:

1. It exaggerates the risk of default, at least the risks of default if debt is mutualized. At low interest rates, most of the crisis countries should have no trouble servicing their debts. Of course, in the absence of debt mutualization, there is a serious risk of partial default (which has already happened in the case of Greece). The irony is that existing arrangements may actually lead to larger losses on the part of creditor countries than a system of well-designed mutualization.

2. Any system of successful economic integration must involve some assistance from the stronger countries to the weaker. Recognizing this, Europe itself has provided substantial funds to new entrants. (These are called the Structural Funds and Cohesion Fund and include multiple programs.) One program, the European Regional Development Fund, provides €40.2 billion to Poland, the top recipient, from 2014 to 2020.7

The reforms just described are key to preventing divergence. Later in this chapter, I will describe further structural and policy reforms designed to promote convergence.


Europe faces two further paramount questions: (1) how to promote stability of the eurozone as a whole; and (2) how to ensure that all of the countries of the eurozone do well. As we have noted, for instance, the Maastricht restrictions on fiscal deficits can effectively be an automatic destabilizer. As tax revenues plummet, when the 3 percent deficit target is breached, there have to be cutbacks in expenditures, which lead to further declines in GDP.8

The current automatic destabilizers need to be replaced by automatic stabilizers at the eurozone level. We’ll shortly provide examples.

Even with reforms that enabled the eurozone as a whole to have stable output and employment on average, there will remain significant differences among countries—some will be in recession, while others are in a boom. With the exchange rate and interest rate no longer in the tool kit, other tools will have to be found to ensure that each of the countries in the eurozone remains prosperous.

There are six parts of a stability reform agenda. The first involves a fundamental reform of the Maastricht convergence criteria. Second, a new growth pact supported by a European solidarity fund for stabilization—akin to earlier European solidarity funds provided for new entrants into the EU that we mentioned above. Third, a commitment to progressive automatic stabilizers that increase spending automatically when the country faces a downturn—and a corresponding ban on automatic destabilizers. Fourth, enhancing the flexibility with which monetary policy can respond to in an economic slowdown within any country. Fifth, in recognition of the fact that markets on their own may create instability, instituting regulations that try to control market-generated instability. And sixth, more active countercyclical fiscal policies, reducing the burden that has been imposed on monetary policies in recent years.


If the eurozone is to work—that is, if it is to provide a framework within which countries can prosper and countries can persistently attain full employment—the first necessary reform is a common fiscal framework. This reform will require more than, and fundamentally differs from, an austerity pact or even a strengthened version of the Stability and Growth Pact—the “reform” that Germany seems to have had in mind, as it calls for stricter enforcement of more stringent budgetary rules. The Germans have emphasized the need for all the countries of Europe to follow the rules—and in particular the budgetary constraints (the 3 percent limit on deficits). They worry that without such rules, strongly enforced, there will be economic chaos—the eurozone won’t be able to function. Germany’s stance is predicated on the belief that profligate government spending leads to crises—and that it led to the current eurozone crisis. That is simply wrong.

Better budget rules

One can still have fiscal discipline by focusing on the structural deficit—what the deficit would be if the economy were at full employment. Many of the crisis countries’ deficits would appear in a markedly different light when looked at from this perspective.9 The most important reform, however, involves creating a capital budget, distinguishing between government spending on consumption from that on investment, with constraints on spending centered on consumption. A government should behave not like the Swabian housewife but like the modern firm—which looks at its balance sheet and undertakes debt if the returns on the investments that it finances exceed the cost of capital.


Addressing the underlying problems of Europe is at its core a collective action problem for Europe, requiring European-wide resources—more resources than are currently available to the afflicted countries.

A year after the beginning of the Greek crisis, it was already apparent that the austerity measures imposed at the very beginning were not helping the economy recover. The leaders of Europe had committed themselves to helping Greece grow. They obviously didn’t do that, and one of the reasons is that they lacked the tools. They had set aside funds to help rescue banks and countries that were in trouble, in the European Stability Mechanism.10 But it was focused on the moment of crisis itself, when a bank was collapsing or a country was shut out of capital markets.

Even for the crisis countries that have done everything that they were told to do, the return to prosperity has been slow. What is needed is enough funding to help countries facing adverse shocks to maintain full employment and grow again. This means, for instance, common funding for unemployment insurance, especially the abnormal expenditures associated with a deep downturn.11 The solidarity fund for stabilization could be used to fund unemployment and other cyclically related social expenditures and to support active labor market policies that help move people into new jobs in a restructured economy.

Even with a successful banking union and common deposit insurance, banks in crisis countries are likely to be weak. The contraction in bank lending is particularly hard on small and medium-size enterprises, which depend on banks for finance. As they are cut off from funding, they have to lay off workers—reinforcing the downward cycle.12 What is thus needed is a European-wide small and medium-size lending facility, like the United States’ Small Business Administration, which provides loans and/or partial guarantees for small business loans; and it should target its lending particularly to countries or regions within a country where there is a shortage of SME lending and/or the economy is showing particular weakness.13

Expanding existing European institutions

Some of the existing European institutions could make a contribution to stability, especially if this was seen as part of their mandate. The European Investment Bank is the largest multilateral lending institution,14 a European-wide institution that has successfully financed infrastructure projects around the region. While it already sees itself as having a countercyclical role, that aspect of its mission could clearly be greatly strengthened.15

Mutual insurance

I have described a variety of forms of support that Europe as a whole could provide to countries with significant economic downturns. One country might be the recipient at one time, but be among the large contributors at another—a quick look at the history of rankings in growth rates in Europe demonstrates the large variability in standings. We have already noted that many of the crisis countries grew faster in the years before the crisis than the eurozone grew as a whole. So, too, for others—for example, from 1995 to 2000, not only did Ireland, Spain, and Greece grow much faster than Germany (with growth rates of 10.1 percent, 4.1 percent, and 3.6 percent, respectively), but so did France (2.9 percent) and Italy (2.0 percent). Germany grew at a rate of just 1.9 percent. Among those countries, Germany also placed second to last from 2000 to 2005 (when it averaged 0.5 percent).


The third part of a fiscal pact for stability focuses on creating automatic stabilizers, so that when the economy faces a downturn, money is injected into the system automatically. Unemployment insurance is an example. Normally, as workers lose their jobs from a negative “shock”—for example, a decrease in the demand for exports—they cut back their spending, so that the effects get multiplied. But if workers are protected with unemployment insurance, this multiplier is short-circuited.

In countries with flexible exchange rates, the exchange rate can act as an automatic stabilizer; a country facing a problem will see its exchange rate decline, and that will encourage exports and discourage imports, increasing national income. But in joining the euro, countries gave up this automatic stabilizer, making it all the more important to strengthen other automatic stabilizers (like progressive taxation and good unemployment schemes and other forms of social insurance). Unfortunately, in recent years, these automatic stabilizers have been weakened. Indeed, the worry is that automatic amplifiers (destabilizers) have been or are being put in place. In particular, earlier, we noted that stringent enforcement of capital adequacy standards for banks would act as an automatic destabilizer, and even more so in the absence of a common deposit insurance system. These are among the reasons that Europe’s current approach to creating a banking union—first having common regulation and supervision, and then, gradually, perhaps, common deposit insurance—is unlikely to work for the foreseeable future.


Previous chapters have described how the existing eurozone acts as an automatic destabilizer in so many ways. One of the worst is through credit: the current design leads to large pro-cyclical movements in credit, especially to small and medium-size enterprises. That is, credit declines when the country goes into trouble, increasing the depth of the downturn. Some such changes are natural: firms in a slowing economy will need less money to expand. But the problem in the eurozone is that those small businesses that do want to expand—they may have customers abroad, for instance—can’t get the finance they need. Some can’t even get the working capital they need to function. Lack of finance is part of the process of strangulation of the economy; chapter 5 noted that the failure to account adequately for the resulting private austerity may help explain why Troika predictions have so consistently been off the mark. If there is to be stability in the eurozone, this has to be reversed.

The eurozone took away two forms of flexibility: in the exchange rate and in the interest rate. But while it is inevitable that the ECB set a single interest rate for the eurozone as a whole, there doesn’t have to be the same rigidity in the application of regulatory standards, especially when it comes to macro-prudential regulations—that is, regulations aimed at stabilizing the overall economy. There needs to be not just a broad mandate, to focus on employment, growth, and stability, but also more flexibility in the way that the eurozone’s banking system is run. Capital requirements (the amount of capital banks have to hold, in relationship to their lending) can be tightened in those countries (regions) facing excess demand. This would force a reduction in lending, which in turn would dampen inflationary pressures there. Similarly, capital requirements could be loosened in those countries facing weak demand. This will strengthen lending, stimulating the economies that need it.

There are a host of other regulatory provisions that can be adjusted according to the macroeconomic circumstances of the particular country or region. As another example, lending standards for mortgages should, for instance, be tightened at a place or time where there appears to be the risk of a bubble forming.16 The key is that there needs to be more flexibility in the way that the eurozone’s banking system is run.

One of the major lessons of the 2008 crisis was that earlier notions of monetary policy were misconceived—they were not only excessively narrow in the mandates that they imposed on central banks but also in the instruments that they provided (suggesting, for instance, that the only instrument should be the short-term interest rate); and even when the need for more tools was recognized, the need for flexibility in their use was not. A key reform for creating a viable euro is creating an ECB and European financial regulatory authorities with broader mandates and more instruments, that are more flexibly managed.


As we’ve seen, in several eurozone countries recent downturns have been a result of real estate bubbles breaking—these bubbles were the result of private sector failures, of a kind that have repeatedly occurred. Excessive credit expansion and excessive risk-taking is frequently the source of economic volatility; financial markets on their own are simply not stable. In other words, an important part of preventing recessions and depressions is to prevent the excesses that give rise to them. Successful control of this excessive expansion needs to be a joint undertaking of the ECB, banking regulators and supervisors, and the broader regulators of the financial system. This won’t be possible in the regime of “light” or “self”-regulation that prevailed prior to 2008. It won’t be possible either if the ECB only focuses on inflation, as conventionally defined. There are tools that the ECB and financial regulators already have, or should have, that can prevent, or at least control the size of, these bubbles.17


While the proximate cause of so much of the economic volatility that has afflicted market economies is the excesses of the financial sector, in some cases central banks condone, if not instigate, this bad behavior. After the tech bubble broke in the early 2000s in the United States, aggregate demand slumped. Politics seemingly did not allow the construction of an effective fiscal surplus, putting the burden on monetary policy; and the United States resorted to the favorite instrument, lowering interest rates. The Bush administration was enthralled with deregulation, and the combination of low interest rates and deregulation was a toxic cocktail. Ben Bernanke and Alan Greenspan, both former chairs of the Federal Reserve, may have been pleased at the scorecard by which central bank governors are usually judged: inflation was low (largely the result of China’s low and competitive prices along with its exchange-rate policy of stable and slow appreciation) and the economy was near full employment. But if one dug deeper, it was obvious that they had turned a blind eye to the excesses that were building up. The same can be said for Willem Frederik “Wim” Duisenberg and Jean-Claude Trichet, the first two governors of the ECB, during whose terms the imbalances that created the euro crisis occurred.

One cannot simply leave the burden of macro-adjustment on monetary policy, regardless of how much faith the neoliberals have in this instrument if it is used correctly (to stabilize inflation). Fiscal policy, directed at needed investments, needs to be put more in the center of macro-stabilization. The United States and the EU both need large amounts of investment for retrofitting their economies for global warming. Both need large investments in education and technology, if there are going to be continuing increases in standards of living. Reduced investments in basic research (as a percentage of GDP) may well result in a slower pace of innovation in the future. Recently, Robert Gordon18 has suggested that we are moving into an era of a much slower pace of increase in standards of living. But this is at least in part a consequence of decisions being made, on both sides of the Atlantic, to invest less in basic research, technology, and education: it is from these that future increases in standards of living will largely come. This runs counter, of course, to conservative ideology focused on downsizing the government. Thus, on both sides of the Atlantic, in some countries, the downturn has been met by cutting taxes for corporations and rich individuals matched by cutbacks in government spending. This book has explained why these policies predictably led to lower output today; but when the cutbacks are in critical public investments, they also lead to lower output in the future.19 The key point is that if fiscal authorities are doing their job well, there will be less pressure on the monetary authorities to create, or at least tolerate, the excesses of which they have so often been a part.20


The absence of the exchange-rate mechanism in Europe means that real exchange rates can get out of alignment, as a result of differences in the rates of growth of productivity or prices across countries. This kind of misalignment occurred in the years before the crisis, partly caused by the euro. There are three parts of the strategy to respond, each reflecting part of the analysis of the underlying causes of the misalignment.21


Generally, one would expect the exchange rate of the eurozone as a whole to be such that it achieves current account balance for the region as a whole. Any country or region maintaining large current account surpluses (or deficits) poses a risk for the entire global economic system. That is why the IMF and the international community have continually talked about global imbalances and tried to get countries not to have them. Surpluses pose a risk because for every surplus there must be a deficit (that is, if some country exports more than it imports, some other country has to import more than it exports), and deficits have to be financed. There can be a sudden stop, in which those supplying such finance suddenly take the view that there is a significant risk that the loan will not be repaid, and refuse to provide further finance or even to roll over existing loans. These sudden stops are a major source of crises.

But if the eurozone as a whole typically has a zero balance, that means if some country runs its economic policy in ways that result in a surplus, necessarily other countries have to have a deficit. The surplus country, in a sense, creates through its actions deficits elsewhere. The surplus countries impose costs on others, an externality, through, in effect, the creation of their deficits. Those trade deficits create, in turn, a risk of instability—for instance, the sudden changes in market moods can result in an abrupt stop in the flow of funds to finance these deficits, setting off a crisis. Even short of a crisis, trade deficits make it more difficult for the deficit countries to achieve full employment, because trade deficits subtract from domestic aggregate demand—on net, some of the demand is being met not by production at home but by imports—and weak domestic aggregate demand leads to unemployment.22To offset the effects of weak aggregate demand, governments in the post-Keynesian world typically resort to government (deficit) spending. Thus, the surplus countries—Germany in particular—can even be thought of as being a fundamental cause of the fiscal and trade deficits and the unsustainable credit expansion in other countries of the eurozone.

One can see this in another way: follow the money. A current account surplus means that a country has to be lending, just as a deficit means that a country has to be borrowing. If the current account of the eurozone as a whole is balanced, it means that the surplus countries (mainly Germany) are, in effect, lending to the deficit countries. If Germany had a surplus (and the eurozone as a whole was balanced), it was necessary that the other countries were borrowing. In some cases, it was the public sector that was borrowing, in others the private. But their deficits were just part of the equilibrium that followed from Germany’s surplus. It was, of course, only a temporary and unstable equilibrium.

I have described how Germany’s surpluses thus almost inevitably led to divergence among the countries of the eurozone. This had political as well as economic consequences. It was recognized early on that differences in countries would result in, say, different monetary policies being appropriate for each.23 That was part of the rationale for policies to promote convergence. Differences in circumstances can also lead to large political differences; differences in economic circumstances led to differences in interests. As we noted earlier, no difference is more important than that between a creditor and debtor, and Germany’s persistent surpluses converted the basis of the eurozone from solidarity to the conflicting relationship of creditor and debtor.24

Europe needs a true convergence policy, and such a policy needs to discourage surpluses. Keynes proposed a solution—a tax on surpluses. This tax would not only discourage countries from having a surplus, but the revenues from the tax could be used to help fund the solidarity fund for stabilization outlined earlier in this chapter.25


There are many policies that the surplus countries undertake that lead to the surpluses. In the case of China, for a long time two policies played a central role: it managed its exchange rate and it controlled wages—for instance, by restricting the scope for unionization. Low wages, in turn, lead to lower prices, and thus a lower real exchange rate.

The first tool is, of course, not available to Germany, but the second has been key. In advanced countries, there are a variety of tools for affecting wages, most importantly minimum wages and the legal framework affecting unionization and bargaining. Until recently, Germany did not have a minimum wage, and the absence of the minimum wage puts downward pressure on wages more generally. Under Chancellor Gerhard Schröeder, incomes at the bottom actually fell.26 While this drop was lauded as making Germany more competitive, these actions are an invidious form of competitive devaluation and beggar-thy-neighbor policy. They gave Germany an advantage over its neighbors, because the social and economic structure of these countries would not tolerate similar inequitable wage reductions. Thus the lowering of Germany’s real exchange rate came in part at the expense of its trading partners.27

Moreover, the current adjustment framework puts the burden of the adjustment on the deficit country, through what I described earlier as internal devaluation. It is a very costly and very asymmetric adjustment process.28 It is, however, typically far easier for the surplus country to take actions to reduce its surplus than for the deficit countries to reduce their deficits. In the end, the global imbalance may be eliminated through either route—but the costs of achieving the eventual “balance” can be markedly different.

Not only should surplus countries raise their minimum wages, they should strengthen workers’ bargaining rights29 and engage in expansionary fiscal policies. They have easy access to funding for such expansionary policies. These policies will put some upward pressure on prices (though far from runaway inflation)—and that’s exactly the point. There has to be an adjustment of the real exchange rate, and these policies achieve that at far lower cost than those of the current eurozone framework.


In chapter 5, I described several other policies that either create divergence or prevent convergence: for instance, Europe’s strictures against industrial policies, which might enable the countries that are behind to catch up.

Rich countries have an advantage over poor ones in many ways. They can, for instance, provide a higher-quality education to their children. Europe can’t correct for all these differences—though in the future, with greater solidarity, it can do a far better job. But there are some differences that Europe can and should address now, including differences in the quality of infrastructure. Good infrastructure (partially financed through the European Investment Bank) can help integrate Europe further. Public infrastructure increases the returns to the private sector and thus can have both supply-side and demand multiplier effects.


Even if the eurozone were to manage all of these reforms and if the countries within it were finally to converge—or at least move closer together—full employment or high growth would not be guaranteed. Europe could have a stable economy beset by low growth and high unemployment. Indeed, that is the direction in which Europe seems to have been moving. It feels self-satisfied if it manages to prevent another crisis—even if a quarter of its young people are unemployed, and even if growth is mediocre at best. There are reforms in both the macroeconomic framework of the eurozone and in the eurozone structure itself that would facilitate full employment with sustainable growth. The key macroeconomic reform is changing the mandate of the ECB.

In the implementation of an expanded mandate to promote full employment, growth, and economic stability, and not just be fixated on inflation, the ECB should have a particular responsibility to make sure that the financial sector is working in the way it should—not only not exposing the economy to huge risks, not only not exploiting the rest of the economy, but actually serving society through the provision of credit for productive purposes, such as lending to small and medium-size enterprises.30 The ECB, like the Fed, has greatly expanded liquidity, yet little of that has gone to create new jobs or make new real investments. Much of it has gone to finance investments in fixed assets, like land, providing no stimulus to the economy. Other lending has simply been part of a round-robin in which the central bank transfers money to the banks, which then hold money (reserves) in the central bank. Someone from the outside looking at this whole process would be as mystified by it, just as someone would when looking at the mining sector where large amounts of money and resources are spent digging up gold (with considerable risk to the environment) that is then, at great expense, buried back into the ground in vaults.


Here, I discuss four common structural reforms that can help ensure sustainable growth with full employment. Many of these reforms entail moving away from the policy framework of the past third of a century—during which neoliberalism dominated and it was presumed that the freer the market, the better—and recognizing the critical ways in which markets often fail to produce efficient and stable outcomes.


Most of the discussion of financial sector reform (including that above, under Reform #2) has focused on preventing the financial sector from imposing harm on others—for instance, through the instability it has brought to the entire economy as a result of its excessive risk-taking.31 Little has focused on ensuring that the financial system actually performs the important functions that must be performed if the economy is to function well. It is precisely this failure that is behind the alleged savings glut: Ben Bernanke attempted to blame the weakness in the global economy before the crisis on excessive global savings, especially in China. But even as he spoke about the savings glut, many firms and countries had high-return investment projects that were not being financed. It is not that there is a surfeit of savings. It is that the financial markets have failed in their basic task of recycling the savings, making sure that the savings are used productively. This function is referred to as “intermediation”—intermediating between savings and investment. Financial systems in both Europe and America have failed to perform this key role well. Indeed, in the United States, the financial sector has been engaged in disintermediation, taking money out of the corporate sector, resulting in fewer funds available for investment. Huge amounts, for instance, are leaving firms in the form of share buybacks—in 2014, some 4 percent of GDP, and in 2015, 3.5 percent.

Moreover, much of the savings is being done by “long-term savers,” those saving for their retirement or money put aside by countries in their sovereign wealth funds. Many of the key investment opportunities (infrastructure and technology) are long-term investments. It is perhaps not a surprise that shortsighted financial markets are unable to intermediate well between long-term savers and long-term investments.

There are reforms in the legal, regulatory, and tax frameworks of Europe that would help focus the financial sector on the long-term—and on doing what it should do, and not doing what it shouldn’t.32


Firms, too, have become increasingly shortsighted, focusing on quarterly returns. A firm focused on the next quarter won’t make important long-term investments in research and technology, in plant and equipment, and, most importantly, in its employees. A firm that pays its CEOs and other executives excessively, and distributes too much to its shareholders through dividends and share buybacks, won’t have enough money left over either to pay its workers decently or to invest in the future.

While these changes have been less extreme in Europe than in the United States, the differences are narrowing. Europe has to understand what led to America’s short-termism, and to make sure that it takes actions to ensure that the disease of short-termism doesn’t spread more to Europe.

It is perhaps not a surprise, given the importance of financial markets on both sides of the Atlantic, that the short-term myopia of the financial markets has spread to the rest of the economy. Some of Europe’s institutions—like “social partners” stakeholder capitalism, where firms are not exclusively focused on the well-being of shareholders, narrowly defined—have successfully proven a bulwark against the extremes found in the United States, where CEO pay has now risen to be 300 times that of the typical worker.33

There are, however, other factors that have contributed to rampant short-termism—for instance, the growth of stock options within the compensation packages of executives. While corporate executives claim that they are an important part of their incentive system, there is in fact little relationship between pay and performance: the stock of an airline will go up, for instance, when the price of oil goes down. Stocks more generally go up when the interest rate decreases. The growth of stock options in turn is related to deficiencies in corporate governance and in the rules governing transparency and disclosure.34 Many shareholders do not realize the extent to which CEO stock options have diluted the value of their holdings. Again, there is a rich and important agenda to reform the “rules of the game.”35 This rewriting of the rules in ways that might result in firms focusing on the long-term would lead to an economy with higher and more stable growth.


A regular feature of capitalism is that firms and households get too indebted; they need a fresh start. That’s why virtually every modern economy has a bankruptcy law, a procedure for the orderly discharge and restructuring of debt.

When, however, there is an economic downturn, such as has plagued Europe for the last several years, then many firms and households wind up overindebted. In the United States, there is an expedited procedure for firms to go through bankruptcy; their debt is written down quickly, so that the firm can continue producing and jobs are not lost. This is called Chapter 11. When many firms and households are simultaneously going bankrupt, it is even more important to have an expedited process—a super-Chapter 11. For in the absence of such an expedited process, there can be economic paralysis. Such a super-Chapter 11 is particularly important in the crisis countries right now.36


A eurozone that works has to have not just high growth but sustainable growth, and sustainability entails not just economic sustainability but environmental sustainability. Once one recognizes the huge investments that are needed to retrofit the economy for climate change, one sees the foolishness of any claims that there is a “savings glut.” But, as we have seen, it will be hard to incentivize firms to make “green investments” if there is no price of carbon—that is, if those who pollute are not forced to pay the consequences of their pollution. That is why it is important for there to be a high, European-wide price of carbon.37


One of the central problems facing the advanced world today is the increase in inequality. As we have noted, inequality affects the performance of the economy in numerous ways. But the eurozone framework limits what can be done to address it.

Free mobility of capital and goods without tax harmonization not only can lead to an inefficient allocation of capital but it can also reduce the potential for redistributive taxation, leading to high levels of after-tax and transfer inequality and in some instances, even market income inequality. Competition among jurisdictions can be healthy, but there can also be a race to the bottom. Capital goes to the jurisdiction that taxes it at the lowest rate, not where its marginal productivity is the highest. To compete, other jurisdictions must lower the taxes they impose on capital. Thus, the scope for redistributive taxation is reduced. (A similar argument applies to skilled labor.)

The eurozone’s structure has not only led to more money (after tax) at the top but also to more people in poverty at the bottom. As the crises in Spain, Greece, Portugal, and elsewhere illustrate, it is the poor who suffer the most from instability.38 Moreover, one of the major factors contributing to increasing inequality is high unemployment, such as has arisen in all of the crisis countries. The failure of the eurozone to create a true stability framework has thus contributed to inequality.

The EU (and this analysis thus goes beyond the eurozone) must adopt two further sets of policies: First, it needs to limit the race to the bottom, the kind of tax competition that worked so well for a few countries like Luxembourg but at the expense of others. This is a real example of an externality—of an action by one country that imposes harms on others. And yet Europe has failed to take adequate action, partially because many in Europe are enamored of the idea of low taxes and a small state, and this kind of race to the bottom suits them fine.

Secondly, given the easy mobility around the European Union, the major responsibility for redistribution must lie at the EU level.39 The EU should follow the United States in levying taxes based on citizenship, wherever individuals are domiciled or resident. And they should impose an EU level tax on all incomes over a certain threshold, say €250,000, at a modest rate like 15 percent. The funds could be used to bankroll efforts, such as resettlement of migrants or foreign assistance. This would perhaps do far more to create political integration in Europe than the euro itself.

A true growth and stability agenda interacts strongly with other elements of the reform agenda: the only sustainable prosperity is shared prosperity.


These structural reforms are necessary for the long-run viability of the eurozone. But they will not be sufficient. Even with a well-designed eurozone structure, there will be shocks that lead some of the countries within the eurozone into a recession. It should be obvious from previous chapters that how Europe has responded has typically exacerbated the downturns rather than restored the afflicted countries quickly to full employment. Dismal policies lead to dismal results. It is imperative that there be a set of reforms in the policies for crisis countries. But as we noted earlier, even the best of policies won’t work unless they are accompanied by (or preceded by) the structural reforms I’ve described.


There are two important aspects of the policy framework that I have noted briefly earlier. Germany has emphasized the importance of obeying the rules. Of course, obeying the wrong rules can lead to disaster—the wrong rules within the eurozone have led to its poor economic performance.

But it is hard to design a set of rules that is appropriate for all countries, in all circumstances. Indeed, we need to admit the limitations in our knowledge. And even if we had a policy framework that was ideal for the economy of 1990, that framework may not be appropriate in 2016.

In its response to the euro crisis, the Troika in fact exercised considerable discretion, but their choices have been frequently wrong—too frequently, in too many important areas. At the time that they imposed the programs, they exuded enormous confidence: they seemed to believe that they knew precisely the consequence of each policy. Afterward, the IMF has often owned up to the mistakes—but the other members of the Troika have been less forthcoming.

If the eurozone is to work, it has to recognize the large differences among the countries, and policy frameworks have to be sufficiently flexible to accommodate these differences. There has to be a greater ability to adapt to differences in economic circumstances and beliefs.40

Some countries, for instance, are more committed to equality than others. Some are more worried about the consequences of unemployment than others. Even within the United States, each state has wide discretion to pursue different policies. The basic principles are understood: those arenas that do not give rise to external effects on other countries should be reserved to the individual countries. (This principle is sometimes referred to within the European Union as subsidiarity.) Some aspects of harmonization may have some slight economic benefit, but there is still a social cost in reducing the country’s own degree of discretion. Getting the right balance is difficult. But at least in some areas, the programs that have been imposed on the crisis countries have excessively reduced their economic sovereignty, with little justification in terms of reducing adverse externalities.

Below, I discuss two necessary changes in the policy frameworks for addressing countries in crisis.


European leaders have recognized that Europe’s problems will not be solved without growth. But they have failed to explain how growth can be achieved with austerity. Instead, they assert that what is needed is a restoration of confidence. Austerity will not bring about either growth or confidence. Europe’s sorry record of failed policies—after repeated attempts to fashion patchwork solutions for economic problems it was misdiagnosing—have undermined confidence.41

The reforms to the structure of the eurozone that I described earlier—including the mutualization of debt, the banking union, and the solidarity fund for stabilization—would provide space for a return to growth: there could be a mutually reinforcing expansion of government spending on, say, growth-enhancing public investments. This could be coupled with government assistance for private lending that would support private investments.

There are two further aspects of this policy reform.42


Europe, like the United States, has relied on monetary policy in its response to the recent economic crises. It has more than relied on monetary policy: both in the United States and Europe, there has been austerity. Monetary policy simply can’t fill the void. And the reliance on monetary policy has resulted in even greater inequality: the big winners are the wealthy, who own stocks and other assets that have increased in value as a result of low interest rates and QE; the big losers are the elderly, who put their money into government bonds, only to see the interest rates generated virtually disappear. In Europe and America, there has been mediocre growth, stagnation, and the beginning of what I predicted in my book Freefall would be the “Great Malaise,” now also called the “New Mediocre” by the IMF.

Indeed, the reliance on monetary policy is setting the economy up for future problems. Because the credit channel hasn’t been fixed, too much of the liquidity that has been created has gone to creating bubbles, threatening future economic stability. For those firms that have access to capital at low interest rates, even though wages have stagnated, in some cases the cost of capital has fallen even more, inducing these firms to use more capital-intensive techniques of production, contributing, over the long run, to unemployment.


Even with restrictions on the size of the deficit, the government can stimulate the economy: increases in spending matched by increases in taxes increases GDP, because the stimulative effect of the spending is greater than the contractionary effect of the (corresponding amount of) taxes. And if the spending and taxes are chosen carefully—say, welfare payments for the poor and inheritance taxes of the rich—then the multiplier can be large, that is, the increase in GDP can be a multiple of the increased spending. Public investments in infrastructure and technology may increase the returns on private investments, and thus stimulate it. Indeed, there are some taxes, like pollution taxes, that can even stimulate the economy even as they improve societal well-being by improving the environment: a tax on carbon emissions, for instance, will induce firms to spend money on emission-reducing investments. Other taxes, like those on luxury cars (all of which are imported into a country such as Greece) improve the country’s current account by discouraging such imports; improve the distribution of income—since taxes on these goods are only paid by the rich; and may promote domestic employment, since they encourage shifting of spending from these imported goods to other goods, some of which are produced by the country itself.

Unfortunately, as we noted in chapter 7, the hidden (and in many cases, not so hidden) agenda of much of neoliberalism has been simply to reduce the size of government.


For most eurozone economies, these reforms would, for now, suffice. But there may be some (like Greece) where the cumulative impact of past mistakes—their own and those forced upon them—is such that more is needed.

The high debt represents a stranglehold on the country’s growth. In the past, there have been three ways that countries have dealt with high debt-to-GDP ratios. Many countries have engaged in inflation, so that the real value of the debt declines. This is particularly effective if the debt is long-term. A second way is to grow the economy: If GDP goes up, the debt-to-GDP ratio goes down. Debt becomes relatively unimportant.

But as we’ve seen, the eurozone has taken these two strategies out of the tool kit. The ECB won’t allow inflation, and the Troika won’t allow indebted governments to spend in order to invest in their country’s future. (Indeed, as we’ve seen, the austerity programs have lowered GDP, thus making existing levels of debt less sustainable—explaining how debt-to-GDP ratios are consistently worse now than they were at the beginning of the crisis.)43 That leaves only the third alternative, debt restructuring. Debt restructuring is an essential part of capitalism. As we have noted, typically, a country has a bankruptcy law that facilitates the restructuring of debts in an orderly way. After the Argentine crisis, there were calls for the creation of a sovereign-debt restructuring mechanism—one of President George W. Bush’s many sins was to veto that initiative. In the subsequent years, when there were no sovereign-debt crises, there was little concern about the issue.44

If some country needs debt restructuring to enhance growth, it should be done quickly and deeply. It is important that the debt write-down be deep—otherwise, lingering uncertainty about the possibility of another debt restructuring will cast a pall over the recovery. By the same token, as we noted earlier, the costs to the economies doing the restructuring may be less than widely assumed and the benefits can be significant. Both theory and evidence suggest that countries which do such restructuring can later regain access to global financial markets, often quickly;45 but even if, going forward, countries have to rely on themselves, rather than turning to foreigners for funds, anyadverse consequences may be far less than the benefits they receive from immediate debt restructuring. A deep debt restructuring provides more fiscal space for expansionary policies, so long as the government does not have a primary deficit. Money that would have been sent abroad to service the debt stays at home.

Argentina has also shown that there is life after debt and that there are large benefits to the reform of monetary arrangements. With these changes, Argentines escaped a years-long death trap where unemployment had soared as high as 22.5 percent in 2002—levels approaching those in Greece today; after the changes, Argentina’s GDP grew at an average of 8.7 percent from 2003 to 2007 until the global financial crisis and unemployment came down to an estimated 6.5 percent in 2015.

Because of the uncertainty about future growth, and therefore of whether a given level of debt is really sustainable, GDP-indexed bonds—which pay off more if the country does well—can be useful in a debt restructuring. Such bonds represent an effective form of risk-sharing between a country and its lenders. These can be thought of, at the sovereign level, as the equivalent of the conversion of debt into equity at the corporate level.46 These bonds have a further advantage: they align the interests of creditors and debtors. With GDP-linked bonds, Greece’s creditors do better if Greece does better. Under current arrangements, Greece bears all of the consequences of the mistaken policies imposed on it from outside. With GDP-linked bonds, creditors like Germany would have an incentive to think twice about these policies.


I have outlined a set of changes to the structure and policies of the eurozone that would enable the eurozone to work—to bring shared prosperity to this region. In one sense, they are modest. They fall far short of the degree of economic and political integration that defines the United States and other federal structures sharing a common currency. But what is required is far more than what exists today.

I have focused on economic reforms that would result in convergence among the European countries and create shared prosperity. These changes would at least hold open the promise of an increase in solidarity among European countries, rather than the divisiveness that has marked recent years. Especially the joint projects—such as infrastructure projects linking Europe closer together and the solidarity funds for stabilization—are likely to promote political integration. But more needs to be done.47 The teaching of history in school, for example, should be broadened so that students learn not just about the legacy of strife in Europe, but also about the continent’s joint battles to establish human rights and democracy.

The euro was supposed to set the stage for further political integration. Many thought it would speed up such integration. Today, we have noted, it is having just the opposite effect. Some suggested that Europe had put the cart before the horse. Closer political integration, with a broader consensus on what good policies look like, is more likely to make a common currency system viable. There are a host of political reforms, widely discussed within Europe, that would strengthen the EU and the eurozone—often, however, at the expense of the politicians who dominate today on the national stages. Not surprisingly, many of these reforms are resisted by politicians who prefer the security of being “a big fish in a small pond” to the prospect of playing an uncertain role in a politically more important EU/eurozone. It was simply naïve to believe that sharing a common currency would change these political dynamics.

SOME MAY LOOK at my list of reforms and argue that it is far from minimal. I believe that reforms that fall short of this comprehensive agenda will substantially increase the likelihood that the euro fails. And if it survives, it will survive without bringing the benefits that were promised. I have repeatedly emphasized that the euro was not an end in itself but a means to broader ends. So far, the euro not only has failed to achieve those broader ends but has had the opposite effects: poorer growth and more divisiveness.

These or similar reforms are necessary to prevent the divergence, instability, stagnation, growth in inequality, and increase in unemployment that have marked the euro. They are intended to cope with the consequences of the absence of exchange-rate flexibility and having a single interest rate prevailing over a diverse region, to make it more likely that the eurozone will perform well in spite of the inherent limitations on adjustment that follow.

The absence of these normal market mechanisms makes it all the more important that the eurozone economic system does not face further impediments, further sources of instability and/or stagnation.

Doctrines and policies that were fashionable a quarter century ago are ill suited for the 21st century. The reforms of this chapter are designed to free the eurozone from its unfortunate historical legacy, and to give it sufficient flexibility to address new problems and to incorporate new ideas as they evolve.

The ECB under Draghi has demonstrated more flexibility than many thought possible—and has done some critical things that many in Germany think is not within its mandate. Still, the ECB remains far more constrained, far less well adapted to the economic realities of today than the Federal Reserve.

Many in Europe would agree on the merits of many, if not most, of the reforms I have outlined. But, they would say, Europe is a democracy and democracies move slowly. Thus, the argument is put, be patient. But the timing and sequencing of reforms are critical, and this is especially so when there is a mismatch between economic and political integration. The creditor/debtor relationship between northern and southern Europe is corrosive. Unless the reforms I have suggested (or something else along a similar line) are made, this corrosion will only deepen. The damage that is being done will be hard to undo.

Markets are impatient, and they will not wait until, perhaps, further reforms are made. The fact that there might be a banking union with common deposit insurance in 2017 is no reason not to take out money from a Spanish or Greek bank now. The downward spiral has already been costly, and even if the decline is arrested, the slow recovery will exert its toll. Europe’s future potential growth is being lowered as a result of the mistakes being made today. There are important hysteresis effects: the generation entering the labor force today will not be building up their skills, creating the human capital that would make them more productive in later years. The term hysteresis simply refers to asymmetries in time and adjustment costs: undoing the imbalances that the euro created in just a few years is taking years far longer than the time required for them to build up, and the costs of undoing these imbalances is far greater than the benefits received as they were built up. So, too, once capital or talented young people leave a country, it is often hard to get them back. Much of the economic debate is about which asymmetries are important. For example, the inflation hawks worry that once inflation increases, bringing it down is costly; the benefits of a short period of high inflation (if any) are far less than the costs of bringing it down. The evidence is that the asymmetries that we are focusing on are far more important.

From what I have seen, however, there is little likelihood of sufficient progress in undertaking the deep reforms in the structure of the eurozone at sufficient speed.48 Delay is costly in another way: as Europe struggles with a flawed eurozone, which is bringing the economic travails that I have described, other crises emerge—most notably, the threat of a breakup of the nation-state in Spain, the threat of the departure of the UK, and the onslaught of migrants, especially from the Syrian conflict. The persistent euro crisis and the conflict over how it has been managed makes it more difficult to develop consensus policies in any of these areas, which would be extraordinarily difficult in any case.

That is why Europe needs urgently to begin thinking about alternatives to the single-currency arrangement—the alternatives that I outline in the next two chapters. Perhaps doing so will increase their resolve to do what it takes—to create a eurozone that works.