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A brief political economy of the euro zone crisis

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In Brief

The EU seems totally consumed by an existential battle to save the euro.

But there are other symptoms of European malaise.


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There is no serious agenda of structural reforms to tackle ‘unfinished business’ in the single market, especially in services and energy. Climate-change policies are increasingly costly at home and are not taken seriously abroad. The EU is becoming less open to foreign workers. And it is taken even less seriously than before as a global force, sometimes even seen as a laughing stock. So, where does the EU go next?

The rootstock of the euro zone crisis is a failed political project: the euro itself. It was pushed through for political reasons — to further ‘ever closer integration’. But the euro zone was never an ‘optimum currency area’, given its diverse economies. Further, there was no structural adjustment in most of the EU; rather, governments flouted common fiscal rules and went on a borrowing spree at artificially low interest rates. The global financial crisis exposed these flaws. The result is a triple crisis — of sovereign debt, banks and the common currency.

Europe’s third-rate political and bureaucratic elites cannot admit to these catastrophic mistakes. They are purblind to the root causes of the crisis and wider ‘eurosclerosis’ — the euro, unsustainable tax-and-spend policies, and repressed markets. That is testament to the narrowness and parochialism of their milieu, not least in the inbred, ideas-deficient village that is Brussels. Hence the resort to half-baked solutions since Greece erupted in 2010: a drip-feed of EU bailouts in return for reform promises (so far unfulfilled in Greece), and buying of government debt by the European Central Bank (ECB). Only very belatedly was there the reluctant admission that the EU periphery suffered from a sovereign-debt crisis rather than a liquidity problem, and that this compromised the solvency of highly indebted European banks.

The conventional wisdom, inside and outside the EU, is that monetary union needs the foundation of fiscal union. That means harmonising fiscal policies among euro zone members through ‘automatic’ rules, centralised monitoring and enforcement, and tough sanctions for those who break the rules. This will have to be backed up by bigger EU ‘firepower’: much more liquidity for severely indebted governments through the European Stability Mechanism (ESM); and additional doses of liquidity from the ECB for sovereign debtors as well as banks. Sovereign-debt restructuring (such as defaults) and bank recapitalisation will be needed as well. So might new ‘euro bonds’. This is the logic of the treaty recently negotiated by euro zone members plus all other EU members except the UK and the Czech Republic. The expectation is that this will save the euro. But will it work?

It is unlikely for three reasons. First, ECB and ESM firepower will have to be in the trillions, not hundreds of billions, to be credible. The Germans will not accept that. The ECB, having already waded into ‘quantitative easing’ through purchases of sovereign debt, will be neck-deep in the junk debt of the EU periphery. The resources of the virtuous will flood into the pockets of the profligate with the promise of future reforms; but wide-open moral hazard will diminish incentives to deliver on those reforms. The Germans will have committed themselves to an open-ended ‘transfer union’, and compromised their own virtue and future into the bargain. Hence they will veer toward halfway-house solutions to save the euro, but that is unlikely to convince the markets.

Second, common fiscal rules will never be automatic. They will be inevitably bargained over and watered down to a low political common denominator, and broken by countries that are unable or unwilling to stick to the rules. That is true of Greece, but could also be true of others including Italy, France and Belgium. This will repeat the history of the failed Stability and Growth Pact for the euro zone.

Third, fiscal union is disastrous political hubris. EU elites are forging ahead with this as they did with monetary union and previous chapters of European integration. But this latest march of top-down integration is probably a bridge too far. The new treaty might even extend to further harmonisation of labour markets and corporate governance. David Cameron was quite right to keep the UK out of such unwarranted intrusions.

In all likelihood, the euro zone will break up sooner or later. Any breakup will reverberate around the world through financial markets. And, by tipping Europe further into recession, it will affect the rest of the world through trade and foreign investment. Most worryingly, an anti-EU backlash in the member-states would ratchet up internal protectionist pressures and threaten the future of the single market. That would spill over into EU protectionism against the outside world.

The EU elite do not have a Plan B — their tunnel vision leads them to conflate the future of the euro with that of the single market and the EU itself. This madness risks becoming a self-fulfilling prophecy. A sensible Plan B would attempt to contain the fallout from a euro breakup, smooth the transition to post-euro currency arrangements, protect the real gains of the single market, proceed with long-delayed structural reforms and keep the EU open to the outside world.

This Plan B would also eschew further top-down integration with its centralised, one-size-fits-all bureaucratic nostrums. Power in the EU should be limited and decentralised to unfetter markets, give individuals more economic freedom, and make politics and policies less cartelised and more competitive. That would give life to the EU’s ‘subsidiarity’ principle, which seeks to devolve as much policy competence as possible to national and sub-national authorities. So far, this has been honoured in the breach.

The EU needs much more bottom-up competition in political and economic markets. It needs more centralisation and cartelisation like a hole in the head.

Razeen Sally is Visiting Associate Professor at the Lee Kuan Yew School of Public Policy and at the Institute of South Asian Studies, National University of Singapore. He is also Director at the European Centre for International Political Economy, Brussels.

A version of this article first appeared in The Straits Times on 7 March 2012.

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