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The international dimension of a fragile EMU

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The international dimension of a fragile EMU


“A bumblebee shouldn’t fly, and instead it does” (Draghi 2012). It is arguably as remarkable as the flight of the bumblebee that the euro area, one of the largest monetary unions in modern history, is embedded in a fiscal and financial framework which is still incomplete. And yet it works. 

Nevertheless, this incomplete nature of the Economic and Monetary Union (EMU), emphasised among others by the ‘Four Presidents Report’ (Van Rompuy et al. 2012), has potential implications not only for the euro area itself but also for the rest of the world. Indeed, the processes of European and EMU integration have overlapped and interacted with global economic and financial integration in the past two decades. Clearly, the euro area is influenced by global shocks – for example, the global crisis of 2007-09 undoubtedly triggered the sovereign debt crisis in the euro area. At the same time, the fragile nature of the EMU has also generated shocks for the rest of the world. The recent Covid-19 pandemic has certainly been a global shock, but it has also induced a discussion within Europe on how to manage the shock and prevent a new fragmentation inside it with implications for the rest of the world. 

Some contributions have already looked at the external implications of euro area crisis events. Stracca (2015) shows that the repercussions of the euro area crisis on the rest of the world have mainly impacted the financial sector via a fall in equity returns, which has been more pronounced for countries with higher trade exposure to the euro area and a currency pegged to the euro, as well as for non-euro area members of the EU. Aizenman et al. (2012) show that the effects of the euro area crisis in emerging economies are significant, but generally smaller than those of the global crisis.

Teasing out shocks originating inside the euro area (e.g. Greece asking for an IMF adjustment programme in 2010) from global risk aversion shocks (e.g. the collapse of Lehman Brothers in 2008) is made difficult by the interconnectedness between the process of European integration and that of globalisation. Indeed, Stracca (2015) finds that euro area crisis events are essentially global risk aversion shocks for the rest of the world. With this question in mind, in a recent paper (Ioannou et al. 2020) we propose an identification method that teases out EMU-specific and global risk shocks. 

Teasing out EMU and global stress shocks

As an overall measure of intra euro area cohesion (‘EMU stress shock’), we consider the average ten-year government bond spread between Italy and Spain on the one hand and Germany on the other (henceforth ‘EASTR’). Although the level of the spread is not, by itself, necessarily an indicator of tension, very large changes and high volatility in the spread typically are (Lane 2020).

We devise an identification strategy in the context of a daily structural vector autoregression (SVAR) model, which complements traditional approaches like sign and magnitude restrictions with narrative restrictions that are informed by well-known events in the crisis timeline (see Table 1). In the baseline specification of the model, the vector of endogenous variables includes: (1) a measure of euro area stress (EASTR), (2) the Chicago Board Options Exchange (CBOE) Volatility Index (VIX), (3) the world equity price index excluding the euro area (‘RoW equity’), (4) the equity price index for the euro area (‘EA equity’), (5) the nominal effective exchange rate of the euro (eNEER), (6) the US ten-year benchmark government bond yield, (7) and the spread of JP Morgan’s Emerging Market Bond Index Plus (EMBI+).

One key element of the identification is that global risk shocks should have a comparatively larger effect on emerging markets sovereign spreads, whereas an EMU stress shock should influence the intra-euro area spreads (proxied by EASTR) more. These restrictions are confirmed when looking at the daily developments in these variables on specific events that can be clearly recognised as global or EMU-specific. In a similar vein, the narrative restrictions reinforce the identification by assuming that the contribution of global or EMU-specific shocks are larger on specific events and variables (for example, that the VIX movements are explained more by a global shock during the Lehman Brothers bankruptcy). 

Table 1 Baseline SVAR restrictions

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Following this identification approach, we find (see Figure 1) on the one hand that an increase in euro area stress exerts a downward pressure on European equity prices and the euro NEER, while also making the US ten-year government bond yield increase. On the other hand, a global risk aversion shock entails an immediate drop in the equity prices for both the rest of the world and the euro area, as well as a substantial decrease in the US ten-year yield and an increase in the EMBI+ spread. Our results then suggest that global shocks work their way through equity markets, while euro area stress shocks have more pervasive negative effects rather through bond markets.

Figure 1 Impulse response functions from daily SVAR: Euro area stress (blue) and global risk aversion (red) shocks

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Notes: Impulse response functions to a ten basis points increase in the EASTR variable and a 0.63 percentage points increase in the VIX. Shaded areas represent 60% highest posterior density (HPD) credible sets.

Do EMU stress shocks matter for the world economy?

A relevant policy question concerns the quantification of the economic effects that EMU stress shocks entail for the rest of the world. We address this question by plugging the series of euro area stress structural shocks, as identified in our SVAR, into monthly panel local projection regressions of several macroeconomic aggregates for a sample of extra-euro area advanced (AEs) and emerging economies (EMs). The dependent variables are given by industrial production, CPI inflation, imports and exports with both the euro area and the rest of the world. On the right-hand side of the equations, we include the euro area and global risk aversion structural shock series, as derived from the SVAR, as well as the US dollar NEER and the oil price as controls.  

Over a one-year horizon, a positive one standard deviation EMU stress shock has significant repercussions in both advanced and emerging economies (see Figures 2 and 3), in that it (1) decreases industrial production and CPI inflation, (2) decreases euro area trade flows due to a decrease in exports and imports with both advanced and emerging economies, and (3) shrinks exports and imports to and from the rest of the world. While these results are symmetrical when disentangling between positive and negative shocks, a comparable decrease in euro area stress (alleviation of stress) is nevertheless found to have more enduring positive spill-overs onto the rest of the world. 

Figure 2 Advanced economies: Impulse responses to a positive one standard deviation euro area stress shock (blue) and a positive one standard deviation global risk aversion shock (red)

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Notes: Inflation is defined as the y-o-y percentage change of the CPI. ∆%: log-change. Shaded areas are 68% HPD credible sets.           

Figure 3 Emerging economies: Impulse responses to a positive one standard deviation euro area stress shock (blue) and a positive one standard deviation global risk aversion shock (red)

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Notes: Inflation is defined as the y-o-y percentage change of the CPI. ∆%: log-change. Shaded areas are 68% HPD credible sets.

Enter the Covid-19 crisis

The ongoing Covid-19 pandemic, mainly a global shock, has revived and intensified the debate on the incompleteness of the EMU architecture. Our approach can prove useful in the context of such a debate by providing some insights on the transmission of shocks emanating from the most salient, shock-generating events also from the euro area, during the Covid-19 crisis timeline. In particular, we expand our data sample until May 2020 and we enrich the SVAR identification scheme by adding some narrative restrictions on top of the ones already included in the baseline setting (see Table 2).  

Table 2 Additional narrative restrictions for the Covid-19 crisis

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We can then interpret the main developments on financial markets over the period January-May 2020 through the lens of our model by considering to what extent EMU-specific shocks played a role during the crisis. In particular, while the contribution of global risk aversion shocks to movements in the main financial variables is overwhelming throughout the time span considered (red bars), which makes sense given the nature of the Covid-19 shock, there are some instances where euro area shocks (blue bars) have become relevant also for some non-European aggregates (see Figure 4). For example, the rise in euro area sovereign spreads in mid-March 2020 had a notable upward impact on the VIX, led to a depreciation of the euro and a rise in the US ten-year yield. 

Figure 4 Historical decompositions, January 2020 to May 2020

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The international dimension of a fragile EMU 8

Overall, we conclude that completing EMU with a fully fledged fiscal and financial union is a priority first and foremost for the euro area itself, but also very important for the rest of the world.

Authors’ note: The views expressed in this column are those of the authors and are not necessarily shared by the institutions to which they are affiliated. We thank Hans-Joachim Klöckers and Neus Dausà i Noguera for useful comments and suggestions. 


Aizenman, J, Y Jinjarak, M Lee and D Park (2012), “Developing countries’ financial vulnerability to the euro crisis: An event study of equity and bond markets”, NBER Working Paper 18028.

Draghi, M (2012), “Verbatim of the remarks made by Mario Draghi”, Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London, 26 July.

Ioannou, D, M S Pagliari and L Stracca (2020), “The international dimension of an incomplete EMU“, ECB Working Paper No. 2459.

Lane, P R (2020), “The monetary policy response to the pandemic emergency”, ECB Blog, 1 May.

Stracca, L (2015), “Our currency, your problem? The global effects of the euro debt crisis”, European Economic Review 74(C): 1-13.

Van Rompuy, H, J M Barroso, J C Junker and M Draghi (2012), Towards a genuine Economic and Monetary Union, Technical report.

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