ADOPTION OF THE EURO: MARKET SIGNALS AND THEIR CONSEQUENCES

Open Access
Author:
Baughman, Tyler Jared
Area of Honors:
Economics
Degree:
Bachelor of Arts
Document Type:
Thesis
Thesis Supervisors:
  • David Shapiro, Thesis Supervisor
  • Stephen Ross Yeaple, Thesis Supervisor
  • Robert Packer, Thesis Supervisor
  • David Shapiro, Honors Advisor
Keywords:
  • European Monetary Union
  • Greece
  • moral hazard
  • signaling
Abstract:
This thesis will argue that when Greece joined the European Monetary Union two signals were sent to investors, which led them to lend to Greece at lower interest rates than the market fundamentals warranted. The first signal suggested that Greece’s economy was no longer dysfunctional and that it was strong enough to be tightly integrated with the advanced economies of countries like Germany. A second signal suggested that due to the high level of integration among EMU countries, the governments of other EMU nations would be required to aid Greece in times of crisis in order to protect their own economies. Thus, investors believed that there was an implicit guarantee on Greek debt. Taken together, these two signals provided a rational for investors to lend with little restraint to Greece. Access to cheap credit supported the profligate spending of multiple Greek governments, which allowed necessary reforms to be postponed. However, without meaningful reforms, the Greek economy was ill-prepared to face the global financial crisis. As events unfolded, it became clear that there was in fact an EMU-backed guarantee on Greek debt. The loans that Greece received to avoid defaulting made this guarantee explicit, so it is no longer tenable to argue that EMU governments will be allowed to fail. Given this, it is prudent for the EMU to develop a permanent bailout mechanism.