The euro at a crossroads.

• Author: Munchau, Wolfgang

It was one of the author's predictions in 1998 that the eurozone would end up teaching us more about economics compared to what economics could teach us about the eurozone. While many of the author's predictions of that year did not hold, including the forecast that the euro would challenge the dollar as the world's foremost reserve currency, this particular prediction ultimately turned out to be correct. A monetary union is a hybrid between a fixed exchange rate system and a unitary state, one that is fully captured neither with closed-economy macro models nor classical international macro models of fixed exchange rates.

In this article, I would like to draw a few preliminary conclusions about the lessons of the euro crisis--preliminary for two reasons. The first is that the crisis was still ongoing at the time of writing, and is expected to continue for some time yet. The second is that we are still gathering new information, and our real-time analysis is thus incomplete. With these two caveats, I will try to draw lessons for the eurozone itself, for others who are considering setting up monetary unions in the future, and for the rest of the world.

Lessons for the Eurozone

The fundamental flaw of the Maastricht Treaty, which provided the legal framework for the euro, was that it provided Jill insufficient framework for a financial crisis, and that it failed to take account of asymmetric shocks. Other criticisms included an inflexible set of fiscal rules and a fiscal compliance procedure whose credibility rested on the presence of fines rather than incentives. While many of these shortcomings were recognized at the time, and voiced by critics, it was a consensus among policymakers than none of these shortcomings would be significant in the long run.

The most important shortcoming with regard to the current financial crisis was an assumption that has been frequently summarized as "no bailout, no default, and no exit." The no bailout principle is explicitly enshrined in Article 125 of the current Treaty on the Functioning of European Union. The no exit principle was enshrined by the simple absence of a provision. The no default principle was not enshrined anywhere, but it was not believed by a majority of market participants. The combination of these three factors essentially precluded any form of crisis resolution in case an entity became insolvent. It remains the official policy to this day although the eurozone has created mechanisms for liquidity support (the European Financial Stability Facility, the European stability mechanisms, the three-year long-term refinancing programmes for banks through the European Central Bank, and the program of Outright Monetary Transactions).

The first lesson of the crisis is thus the need to fix the unholy trinity of "no bailout, no default, and no exit," which constitutes a logical contradiction. The...