The Eurozone's last Hawk: tough talk about the long and arduous path to recovery.

• Author: Weidmann, Jens

About one and a half years after the sovereign debt crisis first came to a head in the spring of 2010, the financial markets and people across the globe are still keeping a close eye on the situation in the euro area. Currently, political efforts are being undertaken to solve the problems associated with the sovereign debt crisis and alleviate its symptoms. However, as the current approach requires ever-more resources, there is a risk that public concerns will increase rather than diminish. Thus, in order to maintain confidence, we have to build a sustainable bridge between short-term crisis measures and a credible and stability-oriented framework for monetary union. What we need is an institutional framework that offers a clear, coherent outlook and provides incentives for the individual parties to act reliably and sustainably. Only with such an outlook in place can the short-term challenges be tackled effectively and the current tensions eased permanently.

To establish the requirements for such a sustainable framework, it is necessary to take into account the peculiarities of European Monetary Union as well as the underlying reasons for the crisis. The sovereign debt crisis was mainly caused by fiscal and economic imbalances in some member states. Ultimately, the combination of a single monetary policy and decentralized fiscal and economic policies proved to be a weak spot in the construction of EMU. In such a union, the incentive for individual member states to incur debt is fairly high: If sovereign debt rises in one country, some of the negative repercussions are passed on to the other member states. This problem was already central to the debate when monetary union was founded. Therefore, the founders of EMU imposed rules, such as the Stability and Growth Pact, which aimed to prevent fiscal imbalances from emerging where possible and to correct them where necessary. These rules have obviously failed. Looking at the run-up to the current crisis reveals, above all, a lack of will to implement the rules, which were either circumvented or even actively bent. Thus, sovereign debt was not effectively contained. Together with other factors such as a loss of competitiveness, asset price bubbles, and excessive lending, this led to a strong deterioration of public finances in some member states.

Taking into account the contagion effects that a crisis of public finances in one country might entail for the rest of monetary union, such a situation...