The euro area crisis first surfaced in 2009 when Portugal, Ireland, Greece and Spain

slipped into recession with exceedingly high budget deficits. The crisis deepened
further in 2010 with credit rating agencies downgrading the sovereigns and banks in
the peripheral Europe. This significantly dented confi dence, even threatening the
very existence of the euro. Consequently, the risks to the global economy rose due
to interconnectedness of financial markets and increasing dependence of the EMEs
on exports and capital inflows.
The problems in the euro area are largely structural in nature and existed even prior
to the crisis. In the years preceding the crisis, the EU became divided between
countries with positive trade balances and sound budgets – the core – and those
with growing budget deficits and external deficits financed by private credit flows
increasingly sourced from the first group of countries for unproductive spending –
the periphery. With the onset of global financial crisis in the US in 2008, the external
deficits, budget deficits and levels of public debt of the countries in the second
group largely became unsustainable once they were no longer financed by the rest
of the EU. In late 2009 Greece admitted that its fiscal deficit was understated(12.7
%of GDP as against 3.7 %stated earlier). This was in violation of the Maaastricht
Treaty which required….
A monetary union without a fiscal union:
The creation of the Euro zone had an inherent contradiction of being a monetary union but not a
fiscal union. The introduction of the euro in 1999 explicitly prevented the ECB or any national central
bank from financing government deficits. As a consequence the central bank has no power to
monetize deficits. The above arrangement put a premium on each country to follow a similar fiscal
path, but, without a common treasury to enforce it. The spending authorities remained national and
subject to their own political compulsions. So long as growth across the region was strong, the fiscal
capacity was not a source of worry. In such an arrangement the possibility of fiscal free riding is
present as seen from the current episode for Greece. Given the differences in the structure and
competitiveness of the peripheral economies, it is not surprising that their compliance to thegrowth
and stability pact was often in breach. And this weakness got further exposed in the after math of the
global crisis due to the operation of fiscal stabilizers,
a rise in the
unemployment compensation
a fall in
tax revenues. The option of improving the competiveness of the economy
exchange rate
depreciation was not available from the very inception of the monetary
The EU budget is only 1 % of the EU GDP and not an effective instrument for fiscal
been a fiscal union
with a system

The country must have maintained a stable exchange rate within the ERM without devaluing on its own initiative. 2. I t has also been argued that the fiscal criteria proved difficult to enforce but generated a false assurance that as long as there was a criteria. unless. the deficit and debt ratio of the peripheral economies may have been contained. all was well. The country must have a public debt that is below or approaching a reference level of 60 percent of its GDP. Among these criteria are: 1. This brings home an important lesson that setting up pacts and codes of conduct by themselves are not enough.5 percent above the average rate of the three EU member states with the lowest inflation. The country’s inflation rate in the year before admission must be no more than 1. 3. 4. They failed to see that other structural problems were far more dangerous to economic stability of the euro zone that included the lack of control and regulation over national financial institutions The Maastricht Convergence Criteria and the Stability and Growth Pact The Maastricht Treaty requires EU countries to satisfy several macroeconomic conver-gence criteria prior to admission to EMU. a fiscal crisis in the periphery automatically translated into zonal monetary and financial crisis with t he central monetary auth ority not empowered to act as the lender of last resort. But in the present case. . The country must have a public-sector deficit no higher than 3 percent of its GDP (except in exceptional and temporary circumstances). the underlying incentives to adhere to them are also reasonably well aligned.horizontal t ransfer and controls.

Th e peripheral economies have lower labor productivity compared to Germany (taken as a bench mark of 100) which clearly stands out in terms of unit labour costs. a large part of the fragile fi scal position in these economies is attributable to expenditure on entitlements due to an ageing population without commensurate increase in revenues and lack of growth-enhancing structural reforms. the intra-euro area financial imbalance remained severe. Apparently the previous government had been misreporting its economic statistics for years. there is substantial variation in terms of productivity.7 percent of GDP. First. . due to low domestic saving rate. the public sector structure has become bloated. and the public debt actually amounted to more than 100 percent of GDP V arying productivity and Structural differences : Within the euro zone . Second. In this process. While the membership of the euro area gave a false sense of comfort to the periphery countries. more than double the numbers announced by the previous government. public debt had to be fi nanced through borrowings resulting in widening of current account defi cit and a growing external debt.The government budget deficit stood at 12.