Figure 2.1 Conceptual framework: Shocks the real exchange rate, institutions and inclusive growth

misallocation of resources into overpriced non-tradables, mainly real estate. In other words, markets pushed for a sharp re-adjustment of the real exchange rate.

The banking crisis quickly turned into a sovereign debt crisis, starting a “doom loop”. When the bubble burst, the liabilities of the inadequately capitalized banks were transferred to the public sector, in order to prevent the banking system from imploding. Markets sometimes judged the sovereign not to be able to take on these debts, sending sovereign bond rates soaring, which in turn negatively affected the banking sector. Recall that the ECB was explicitly forbidden from lending to the sovereign: euro borrowing in effect turned out to be “foreign” borrowing, because the eurozone’s bank was not the lender of last resort of the eurozone members31 .

Within the European Union, the eurozone was particularly affected as a result of its deep and unhedged financial integration. In Germany, the Netherlands and Belgium, the liabilities of the “too big and too inter-connected to fail” banks were underwritten or taken over by their respective governments in an orderly fashion. However, in some other countries, given the magnitude of the misallocation, creditors suddenly deemed the external debt position to be unsustainable32. Where the markets perceived that these additional liabilities could not be shouldered, sovereign debt crises broke out, as was the case for Greece, Ireland, Portugal and Spain. “Double drowning” was an apt description: as the banks drowned, governments came to the rescue, risking drowning themselves33. These crises broke out at different levels of relatively modest departures from the Maastricht-SGP fiscal deficits and debt-to-GDP ratios34. By late 2009, when Greece revealed that its true public-sector deficit and debt position were far worse than it had reported35, the EMU suddenly faced two crises: a banking crisis and a sovereign debt crisis—the euro crisis36 37 .

Maastricht had not adequately assessed the potential risks of cross-border banking activities. Experience demonstrated that in deeply integrated markets, a banking crisis in one country could easily spill over into other countries. The Maastricht convergence criteria had included certain institutional reforms for the banking sector at the national level, such as making central banks independent. And the Delors Report had been prescient about the inefficiency of capital markets after euro adoption: the interbank money markets would not price in the country risks or were counting on an implicit sovereign guarantee from member states3839. But the Maastricht agreement had not anticipated the many coordination, accountability and regulation issues that would emerge in the monetary union with decentralized banking supervision40. When the crisis broke out, it demonstrated that the coordination mechanisms deemed to govern cross-border banking in the monetary union were not up to the task. In addition, institutions with regard to accounting rules differed substantially between the members of the monetary union41. And even when formal rules were identical, the operational interpretation and enforcement of the rules and informal institutions were not42 .

Did labor migration assist in dealing with economic shocks? An important substitute for an independent monetary policy could be the movement of workers across national borders. In theory, EU member states’ labor markets could assist in absorbing exogenous shocks by moving labor from high to low unemployment areas. To what extent did this happen?

In Europe, cross-border labor mobility is relatively low. It is lower than in the US and Australia, and more similar to labor mobility in Canada, which has an analogous language barrier4344. As a result, only 4 percent of the EU population can be considered “mobile”: they live in another state than their own. But this hides stark differences: only one percent of Germans, but about 20 percent of Romanians do45 .

The mobility of labor within the EU is also still very much constrained by “guild”-like entry and conduct restrictions in the various member states. Whereas the freedom of movement is a core freedom of the EU, in practice many professions restrict entry by foreigners46. This creates additional barriers to labor migration as a response to regionally concentrated, permanent economic disruptions. To be