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Hostages, free lunches and institutional gaps: the case of the European Currency Union


This paper argues that the strong member states of the European Currency Union are hostages of a financially distressed member state so that they are compelled to provide financial support. Moreover, due to the dynamics of the interaction game, a debt relief is a free lunch for the distressed country. This fosters moral hazard of distressed countries. In the absence of capital market control, European politics do not effectively monitor fiscal politics of member states. The lack of a long-term strategy of the European Currency Union to deal with distressed states has undermined the credibility of politics. This lack is also explained by a lack of a European Insolvency Charter. A viable Union requires such a charter with rules for handling distress. Moreover, politics should determine a mechanism to coordinate politics and capital markets in their monitoring of fiscal and economic policy of member states.

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  1. 1.

    The European Central Bank may finance current account deficits through the Target 2 system. But it is not allowed to provide money to a government or other public authorities to fund budget deficits (see Sect. 2).

  2. 2.

    This may also explain why some East-European member states of the EU which, however, do not belong to the ECU, and many developing countries have rather low public debt.

  3. 3.

    Art. 143 also allows the EU to support member states in case of current account imbalances and associated foreign exchange reserve problems. But this applies to member states which are not members of the ECU.

  4. 4.

    The ECU raised the EFSF-volume to 440 bio and added 60 bio € from the European Financial Stabilization Mechanism while the IMF promised to back a 250 bio € loan. In order to financially support distressed member states, the EFSF can also provide partial guarantees for newly issued bonds of the member states. This leveraging allows the EFSF to support bonds with a par value of more than 1 bio €.

  5. 5.

    This led to the strange implication that credit default swaps on Greece did not pay any damage claims even though bondholders suffered substantial losses.

  6. 6.

    The ECU insisted on an austerity program of Italy. The Italian government sent a letter to the ECU in which it promised certain steps together with a time schedule for implementation. Moreover, Italy had to accept official monitoring by the IMF, in addition to that of the ECU.

  7. 7.

    However, a random exchange rate also offers real options to exporters and importers which may encourage international trade (Franke 1991).

  8. 8.

    Sometimes it is argued that a penalty for Greece would be to establish an external austerity commissioner with strong power in the Greek administration. The troika has already a similar role. It is questionable whether the chances to implement an austerity program are better if an external commissioner takes responsibility instead of the Greek government/parliament.


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I am indebted to Manuel Ammann, the editor, Matthias Draheim, Angela Franke, Moritz Heimes and Steffen Seemann for very helpful comments.

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Correspondence to Günter Franke.

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Franke, G. Hostages, free lunches and institutional gaps: the case of the European Currency Union. Financ Mark Portf Manag 26, 61–85 (2012). https://doi.org/10.1007/s11408-011-0176-8

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  • European Currency Union
  • European Insolvency Charter
  • Hostages
  • Free lunch
  • Externalization hypothesis

JEL Classification

  • E62
  • F36
  • F53
  • H30
  • H60