European economy is resilient.

The European Project looks in trouble once again. Mounting political extremism, feeble growth and the loss of its second largest economy shape a convincing case that the integration of Europe’s political and economic institutions has failed to deliver. The common currency, it appears, has created more mutual resentment among its members than mutual solidarity, and the calls for more exits has led many to conclude it was all a terrible mistake. And yet, it survives and in many ways prospers. The reinforcement of euro area institutions following a sudden stop in global financial flows suggests a surprising resilience. Indeed, the euro as a store of value did not suffer directly from the crisis. And for all the gnashing of teeth, euro area governments were forced to double down on their commitments to one another under the skeptical watch of global financial markets. Even in the face of certain voter rebellion, they opted for measures for integration rather than separation or dissolution. For a project that is perennially on the verge of collapse, it is worth re-examining how these leaders committed significant sums of taxpayer resources and agreed to an unprecedented sharing of sovereignty.¶ This paper argues that the resilience comes from the deep financial integration of the currency union that created both stronger links of interdependence among its members as well as greater flexibility to absorb shocks. On the one hand, the financial market turmoil made it painfully clear to European leaders that investors viewed Europe as more or less a single borrower notwithstanding a treaty that said otherwise. On the other hand, this integration, especially through the banking system, provided mechanisms to reallocate resources throughout the currency union in order to absorb the asymmetric hocks through liquidity injections, market purchases and the euro area payments system. Like the large noisy family they claim to be, European leaders found themselves stuck with the costs of their relatives’ mistakes, yet able to reallocate emergency resources under the table even as they sought to set up formal new rules to provide support and enforce discipline. If there is an optimistic case to be made for the euro area, it may be that strengthening its Banking Union can proceed even as the political climate makes structural reforms, fiscal pooling or labor mobility more difficult.2 Moreover, financial market forces may encourage progress on banking supervision and stability in spite of lingering voter doubts. Arguably, the European political calendar over the next year will put these ideas to their most severe test yet in key national elections. Until now, however, the “Financial Education of the Eurozone” is both the story of global markets forcing political leaders to take unpalatable steps to reinforce their monetary union, and the dawning realization that this very interdependence through markets and banks will likely drive further integration. Steady progress on the technical steps required to enshrine Banking Union and capital market integration may not be sufficient to secure the euro’s long-term survival, but they are necessary and realistic next steps amid the current political turmoil.¶ Europe still falls far short on key elements of what constitutes an “optimum currency union” (Mundell 1961; McKinnon 1963; Kenen 1969). Roughly summarized, economists have cited four key criteria to achieve optimality: factor mobility, including especially capital and labor, pooling of fiscal responsibility and synchronization of business cycles. Moreover, the political will to accept the economic policies of other members can make or break a currency union (Frankel 2004). While capital mobility has been relatively free within the euro area--and this paper argues crucial in keeping the common currency together--labor mobility has been more constrained. The absence of a common language seems to be a detail that many early champions of the common currency assumed away. As for fiscal integration, of course, the euro area has no central fiscal authority, with the EU budget itself representing only 1 percent of gross domestic product. On business cycles, while Europe’s commercial links were deep, it became clear from the emerging imbalances that these economies were hardly synchronized.3 These failures, in the context of a single currency, have substantially slowed the European recovery such that only in 2014 had it returned to its levels of output before the crisis.4 As for political will, even the successful summits have often come amid sniping and threats. Arguably, the costs of membership have rapidly surged to exceed the potential benefits.5¶ Indeed, the classic cyclical shock to a monetary union tips some member states into recession and opens disparities in growth rates and unemployment levels that are then locked in by a single currency. With other parts of the union relatively unaffected, there is no incentive to make the difficult decision to share resources for more than humanitarian needs. This leaves the only path of adjustment through a grinding nominal decline in wages and prices that triggers recriminations, populism and ultimately the decision to exit. In the case of the global financial crisis, the shock to Europe revealed very different problems in different places: a fiscal gap in Greece, a property bubble in Ireland, low growth in Portugal and myriad banking issues in Spain, Italy and Cyprus Left to fester individually, none of these disparate problems would have forced a significant response from other European members, either in terms of new rules to bolster better policy or new money to soften the pain of adjustment. As such, it is not difficult to imagine a much more turbulent series of events that included more than one euro member exiting the union¶ What early observers saw less clearly, however, was the surprising integration and interdependence of the member states through financial markets and their banking systems.6 If trade and investment did not flourish as promised, the single currency did open enormous opportunities in banking and finance. Banks rapidly expanded their exposures to other euro markets in search of higher returns where currency risk had apparently disappeared.7 This led to European economies that were both more integrated with one another and at the same time more susceptible to one another’s risks. Thus did isolated national issues like Greek public payrolls and Irish overbuilding suddenly become everyone’s problem. Each of these qualitatively different economic imbalances was quickly transmitted as large, undifferentiated potential losses through the financial system. Some of these potential losses arose from direct lending by French and German banks, for example, to the periphery. Some appeared from nowhere as suspicion turned to fear that much larger countries like Spain and Italy might lose market access. In any case, the sudden transmission of the global shock throughout the European financial system forced European leaders to pool resources and share sovereignty in ways that would have been unimaginable before the crisis. Whenever the price of further pooling of sovereignty and resources looked unacceptably high, euro governments determined that the costs of dissolution would be even higher and could not be compartmentalized. Indeed, most leaders chose policies that eventually lost them their own jobs over the prospect of immediate financial calamity.8¶ This study reviews the historical and political context that shaped European monetary union through the financial crisis, and then traces how unexpected financial market pressures forced European leaders to sweep aside treaty restrictions in order to build a joint fiscal backstop and consent to active central bank intervention on their joint accounts. A third section explores the efforts to encourage, and at times impose, structural reforms, which created a framework to address the currency union’s structural imbalances, even if its credibility remains dubious. Fourth, the study examines the financial interdependence of the currency union that, for all the concerns about fiscal transfers, actually provided a mechanism for financial transfers that helped absorb the shocks. At the same time, these deep financial linkages also made each member vulnerable to the instability of the others and prompted euro governments to impose unprecedented centralized supervision on their own largest banks. In a fifth and final section, this paper assesses the resilience of what must for the foreseeable future remain a “suboptimum currency union” and suggests a policy agenda to secure the recent gains. While further fiscal integration or structural reforms that boost labor mobility may be difficult to imagine short of another crisis, steady and quiet progress on banking union may still be possible. The outcomes are hardly inevitable, as political leaders could miscalculate and voter moods could sour further. Competitive adjustments and structural reforms do not immediately boost growth, which creates fertile ground for populism and isolationism. 9 Still, the lesson of the last several years suggests that members of the euro area must either hang together or hang separately. Ironically, perhaps, the same integration through financial markets and banks that makes members of Europe’s currency union vulnerable to one another also makes the entire structure more likely to endure. As one journalist put it, Europe finds itself in an unhappy marriage with prohibitive divorce costs (Walker 2016)