The Shift of the Current Financial Crisis into a European Sovereign Debt Crisis: What Lessons Can We Learn?

This paper discusses several key issues regarding the European twin sovereign debt and banking crises. The shift of the current financial crisis into an European sovereign debt crisis is afforded analysing how was it that via the banking system the contagion was extended from the US to Europe. The explanation focuses on the imbalances of European Monetary Union countries balance-of-payments. These are very difficult to adjust because of the new experience of a monetary Union of independent political countries which mantain different and not completely convergent fiscal policies: a situation which is different from traditional monetary unions of States belonging to the same political Union. The European crisis has shown that crises can spread quickly among closely integrated economies, either through the trade channel or the financial channel, or both. In an integrated region, no country can isolate itself from surrounding troubles. The crisis has exposed a major deficit of executive decision-making capability in the EU and Eurozone institutional framework, which helps to explain the insufficient policy response. It can thus be said that the banking and sovereign crises are compounded by a crisis of the EU institutions themselves. Therefore, a successful crisis resolution requires more political integration, which will need to include: first, a mechanism that ensures that fiscal policies in the Eurozone are partly centralized; and second, a framework for banking policy at the European level that credibly supports the vision of a single European market for financial services.