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Making the European Monetary Union

Harold James
Belknap Harvard

Beginning in 1999 the ESCB's Banking Supervison Committee per­formed regular macroprudential analyses of the EU banking sector. From 2003 on, its findings were published in an annual report titled "EU Bank­ing Sector Stability." An EU memorandum of understanding set out a basis for flows of information and for identifying the appropriate au­thority to take the lead in the event of a crisis. There was some recogni­tion that this was a rather weak halfway house between national regu­lators and a truly European mechanism. In 2008 the ECB stated: "the Eurosystem's framework for monitoring and assessing financial stability requires further improvements. An important challenge in this regard— not only for the Eurosystem but also for central banks and supervisory authorities worldwide—relates to the development of enhanced quanti­tative approaches to identifying financial stability risks and to assessing the potential impact of the materialisation of these risks."

Governments as well as private borrowers increasingly financed themselves from abroad—but from within the Eurozone. In the wake of the transition to monetary union, debt holding became international­ized. This is what distinguishes the European experience from that of another economy that has also built up a high debt burden. Japan, de­spite a horrendously high proportion of debt to GDP, is usually thought to be very stable because the lenders (debt holders) are overwhelmingly domestic. They are also aging, and thus need to hold investments to pay for their retirement. In consequence, there is an overwhelming home bias. Until the late 1990s and the advent of monetary union most EU government debt was domestically held: in 1998 the overall ratio of foreign-held debt was only 1:5. That ratio climbed rapidly in the after­math of the introduction of the Euro. In 2008, on the eve of the finan­cial crisis, three-quarters of Portuguese debt, half of Spanish and Greek debt, and over two-fifths of Italian debt was held by foreigners. A sig­nificant proportion, especially in the case of Greece, Portugal, and Italy, was held by banks…

The same trajec­tory occurred in the United States, from fiscal responsibility in the 1990s (under President Clinton) to persistent high deficits in the 2000s under Bush.