The Euro was always about liberalisation of European financial markets which would be guaranteed by each state in the event of a crisis

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The Euro was always about liberalisation of European financial markets which would be guaranteed by each state in the event of a crisis

The purpose of the Euro was to liberalise money flows in the EU, generating massive income for European banks, but ensuring that each state was individually responsible for bailing them out when a banking crisis struck, as Paul de Grauwe explained in 1998:

“EMU is certainly going to dramatically increase the degree of capital mobility within the euro area. Today, it is still the case that European capital markets are relatively closed. Financial institutions and insurance companies in Germany, France, Italy, etc. hold an overwhelming share of their total portfolio (often more than 90%) in domestic assets. The complete elimination of foreign exchange risk following the introduction of the euro and the disappearance of regulatory constraints on the holdings of “foreign” euro assets will change all that, leading financial institutions to dramatically increase their holdings of “foreign” euro-assets. The result will be to open up financial markets in Europe in a more profound way than in the 1980s when most European countries eliminated their systems of capital controls. The size of the funds that will be freely moving within the euro area will make a quantum jump.

Against the background of this dramatic liberalisation of Europe’s financial markets there is the fact that the regulatory and institutional environment will not be adapted. Prudential control will still be done at the national level. This will handicap the regulators in assessing the risk of the institutions under their jurisdiction. In addition, financial institutions in each country of the euro area will, at least initially, overwhelmingly be national. The German financial markets will be dominated by German financial institutions, the French markets by French institutions, etc. Thus, institutionally the financial markets will still have a substantial domestic segmentation. This will make it difficult to efficiently spread the risk of asymmetric economic shocks, i.e. economic shocks occurring in one country and not in others.

The conditions that could lead to financial disturbances will, therefore, be present in the future euro area, at least during its initial phase when institutions have not yet adapted to the new environment. This, of course, does not mean that crises must inevitably occur. In order to gauge the risk of such occurrence let us analyse a particular scenario.

Suppose a country, which we arbitrarily call Spain, experiences a boom which is stronger than in the rest of the euro-area. As a result of the boom, output and prices grow faster in Spain than in the other euro-countries. This also leads to a real estate boom and a general asset inflation in Spain. Since the ECB looks at euro-wide data, it cannot do anything to restrain the booming conditions in Spain. In fact the existence of a monetary union is likely to intensify the asset inflation in Spain. Unhindered by exchange risk vast amounts of capital are attracted from the rest of the euro-area. Spanish banks that still dominate the Spanish markets, are pulled into the game and increase their lending. They are driven by the high rates of return produced by ever increasing Spanish asset prices, and by the fact that in a monetary union, they can borrow funds at the same interest rate as banks in Germany, France etc. After the boom comes the bust. Asset prices collapse, creating a crisis in the Spanish banking system.”