Working Paper: CEPR ID: DP9415
Authors: Maurice Obstfeld
Abstract: Because of recent economic crises, financial fragility has regained prominence in both the theory and practice of macroeconomic policy. Consistent with macroeconomic paradigms prevalent at the time, the original architecture of the euro zone assumed that safeguards against inflation and excessive government deficits would suffice to guarantee macroeconomic stability. Recent events, in both Europe and the industrial world at large, challenge this assumption. After reviewing the roots of the euro crisis in financial-market developments, this essay draws some conclusions for the reform of euro area institutions. The euro area is moving quickly to correct one flaw in the Maastricht treaty, the vesting of all financial supervisory functions with national authorities. However, the sheer size of bank balance sheets suggest that the euro area must also confront a financial/fiscal trilemma: countries in the euro zone can no longer enjoy all three of financial integration with other member states, financial stability, and fiscal independence, because the costs of banking rescues may now go beyond national fiscal capacities. Thus, plans to reform the euro zone architecture must combine centralized supervision with some centralized fiscal backstop to finance bank resolution and deposit insurance.
Keywords: banking union; euro crisis; financial stability; trilemma
JEL Codes: E44; F36; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial vulnerabilities (F65) | euro zone crisis (F36) |
| financial integration (F30) | financial stability (G28) |
| financial integration (F30) | national fiscal independence (H69) |
| lack of centralized fiscal support (H77) | euro zone crisis (F36) |
| doom loop (C69) | bank solvency (G21) |
| doom loop (C69) | sovereign debt (H63) |
| bank solvency (G21) | sovereign creditworthiness (F34) |
| sovereign creditworthiness (F34) | bank solvency (G21) |
| national fiscal resources (H69) | financial instability (F65) |