Financial Factors in the Economic and Monetary Union

This thesis analyses how the growing importance of financial factors has affected the functioning of EMU during the sovereign debt crisis. Rapid financial integration and development amplified existing vulnerabilities in the monetary union and but also created new ones that were not foreseen. Chapter 2 looks at the current account imbalances in EMU. We investigate the role of price competitiveness and of domestic demand related to the financial cycle. We find that both matter, but that the financial cycle was more important. We argue for more emphasis on financial and macroprudential policy in EMU, next to competitiveness and structural reforms. Chapter 3 looks at the symmetry of fluctuations in EMU. We show that medium-term fluctuations are much less symmetric than normal short-term fluctuations. They have also become more correlated with financial factors like credit and house prices. Our medium-term perspective paints a less benign picture of the functioning of EMU that is in line with the debt crisis. Chapter 4 investigates the increase in sovereign bond yields in the debt crisis. We examine whether yields can be explained by macroeconomic fundamentals, and find that several fluctuations cannot. This suggests that some mispricing took place, but outcomes are strongly affected by modelling choices. Chapter 5 discusses the institutional setup of EMU. We describe the weaknesses in the original setup and the reforms implemented since then. They are major achievement, but an imbalance looms between the degree of risk sharing and the degree of national sovereignty. We propose ways to improve this balance.