DP9521 How the Euro Crisis Evolved and How to Avoid Another: EMU, Fiscal Policy and Credit Ratings

Author(s): Vito Polito, Michael R. Wickens
Publication Date: June 2013
Keyword(s): credit ratings, EMU, euro crisis, fiscal policy
JEL(s): E52, E62, H63, H68
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9521

This paper argues that the crisis was an outcome of EMU: setting a common monetary policy for countries with different initial inflation rates. The crisis countries were those with high inflation rates which then had negative real interest rates and consequently over-borrowed. Current policy discussions focus on crisis measures: fiscal, banking and political union, not avoiding another crisis. This paper suggests two ways to avoid a future crisis: offset an inappropriate monetary policy using fiscal policy; markets could better price loan rates by taking into account default risk. The paper shows that neither was done prior to the crisis.