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When the euro was launched in 1999, most experts believed that the new policy
regime would be conducive to economic discipline. Many had hoped that by increasing price transparency and cross-border trade, the euro would force reluctant European Monetary Union (EMU) members into structural reform. However, as time has passed, this hope has proved too optimistic.

Structural fiscal deficits in the euro area have tended to deteriorate since the introduction of the currency and there is evidence of reduced appetite for structural reforms. Since the beginning of the global financial crisis, the financial situation of EMU-member countries has worsened further and governments all over Europe have spent billions of euros on attempting to mitigate the blow to their economies.

At the same time, these countries have also tried to assist some EMU applicant countries by providing additional financial rescue packages (directly or indirectly through the IMF), as borrowing funds in capital markets has become increasingly difficult for some EMU candidates. While these policies have cushioned against
short-term detrimental effects of the global financial shock, they may create negative political economy spillovers and moral hazard problems in the long-run.

As enlargement of EMU will increase its diversity, it is possible that some EMU member states may try to exert political pressure on other nations to provide additional financial bail-outs, possibly threatening the sustainability of the monetary union. The effectiveness of such pressure will depend on the magnitude of the economic woes and the size of the given country, as well as hinge upon the capabilities to form coalitions with other affected countries.

The provision of rescue packages (as has recently been the case with, for example, Hungary, Latvia, and Romania) would create an extra fiscal burden for EMU members. The costs of a bail out, in turn, would add to the risk of an inflationary debt, which would have a negative effect on the monetary policy credibility and thus price stability within the euro area.

Eventually, the increasing fiscal burden paired with high inflation may reduce the advantages of some EMU members of sticking to the euro. As the opportunity costs of possibly deteriorating price stability within the euro area decrease, not only individual exits but an entire breakdown of EMU will become more likely.

While all European countries will face short-lived costs in the course of the financial crisis, the long-run costs in terms of deteriorated monetary credibility particularly concerns EMU-members. The latter costs occur in the form of a surge in inflation rates and country-risk premium due to ever increasing levels of fiscal debt. It is therefore in the long-term interest of the European Union, to create an institutional set-up that would balance the needs for short-term flexibility with the demands of long-term sustainability demands - particularly, by effectively preventing the possibility of inflationary debt bail-outs.

The increasingly exposed structural deficits of EMU members and applicants will result in more pressure on the already battered Stability and Growth Pact. It remains to be seen, whether the global financial crisis will wreck the sustainability of the euro area and the ambitious goal of unifying Central and East Europe economically.

Christian Fahrholz is Chair of Political Economy at the University of Mannheim. Julian Börner is Junior Researcher at the Chair of Political Economy, University of Mannheim. Cezary Wójcik is at the Polish Academy of Sciences.

Related Materials from the Atlantic Community:

• Soyen Pak: The Legacy of the Financial Crisis Awaits us in 2020
• Maie-Brit Rüter: Re-evaluating Economic Governance in the Financial Crisis
• William L. Silber: Will the Euro Dethrone the Dollar?