Luis Garicano on the Future of Digital Money and Lessons Learned from the History of the Euro

Luis Garicano is a former member of the European Parliament and a professor at the London School of Economics. In Luis’s first appearance on the show he discusses his new book, Crisis Cycle: Challenges, Evolution, and the future of the Euro, the ever-changing landscape of digital money, his suggested reforms to the Euro, and much more. 

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This episode was recorded on June 18th, 2025

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]. 

David Beckworth: Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow at the Mercatus Center at George Mason University. I’m glad you decided to join us.

Our guest today is Luis Garicano. Luis is a former member of the European Parliament, a professor at the London School of Economics, and a co-author of the new book, Crisis Cycle: Challenges, Evolution, and Future of the Euro, alongside John Cochrane and Klaus Masuch. Luis joins me today to discuss his new book as well as the future of digital money in Europe. Luis, welcome to the program.

Luis Garicano: My pleasure to be here. Thanks for inviting me.

Future of Money

Beckworth: It’s a real honor to have a past member of the European Parliament as well as an economist. I was really thrilled to meet you this past May in Stanford at the Hoover Monetary Policy Conference. I love going to those conferences. I always enjoy them, but your panel was probably the best one there by far because it talked about the future of money, the digital forms of money. All the other panels, I could probably predict what they were going to say. I still loved them. Your panel was super fascinating. You had Darrell Duffie, Charlie Calomiris, yourself, and just a fascinating conversation.

Garicano: Larry Summers.

Beckworth: Larry Summers, that’s right. You had this really fascinating conversation on the future of digital money in Europe. Particularly, you talked about how dollar-based stablecoins may just run completely through Europe, and the approach the Europeans are taking, which is toward the CBDC, may not work.

It was just really striking. You showed a graph that had the percent of stablecoins, and it’s like 99 point something. Just very small sliver of anything but a dollar stablecoin. Walk us through that presentation, and why talk about it?

Garicano: The situation in Europe, broadly, as you know, is a concerning situation, and mostly because of regulation, to be honest. I’m not talking about payments. I’m talking about regulation more broadly. Europe is really going through a second decade of little to no growth. The sense that we get, and there was a report by Mario Draghi emphasizing this, is that there is a lot of overregulation and there is a lack of single market.

The crypto area is particularly interesting and the future of money because Europe is concerned. We take a defensive posture, as with many other things. Exactly as you said, David, 99.75% of the stablecoin market is dollar-denominated. The euro is there, some rounding error, as you said. The fear in Europe is the idea of digitalization. 

The fear is that, if stablecoins proliferate—remember the moment with the libra. The libra is the moment that Europe got the shock with this. Imagine that libra had succeeded. It was the one that Facebook Meta proposed. People just have their wallets in their WhatsApp, and they go around paying, and the money goes around the world through dollar WhatsApp payments, and that displaces the euro. Now, who cares? Now we go to the stablecoin. Who cares about that? Well, Europeans care because they think, “Look, there is financial stability risks if people are getting liabilities in dollars, assets in euros, then we have a currency mismatch.”

There is also a difficulty of letter of last resort operations in a world where you’re going to have dollar-denominated payments. We also have a macro risk. How do you do monetary policy if people are not using your euros? There is also, of course, Europe always worries about the sovereignty issues. Then Europe says, “Oh, we fear these stablecoins, and we will go back into how we’re regulating that. Let’s do”—and that was the response to libra—“a digital euro, a digital wallet.”

Digital is more than a payment system. I’ll explain it in a second. It’s what is called a CBDC, central bank digital currency. The idea is people have their little credit card, but instead of going to a deposit account, which is in a bank, it goes directly to the deposit account in the central bank.

Now, this is an obvious problem, which, in some sense, it’s too good. It’s a completely risk-free asset you could find and as risk-free as you could get, and it’s completely liquid. The risk is that this thing works very well. The risk is if this thing works very well, people will take their money out of banks and put it into the CBDC. The way Europe has faced this design problem is, “Oh, let’s not make this thing too good. Let’s make it just good enough.”

This is an unusual design problem in which the central bank and the commission are saying, “How do we make a payment system that is pretty good, but not so good that it hurts the banks?” Of course, the risk when you do, you design the next, I have a Samsung, not an iPhone, but if you do the next iPhone and you say, “Well, I’m not going to do it great,” is people won’t like it. Normally, you try to design the best product you can. That’s more or less where Europe is.

Just to compare with the US briefly, Europe is kind of restricted of stablecoins and pushing a central bank digital currency. The US is absolutely committed not to introduce a CBDC. Particularly, Donald Trump has completely ruled it out and full-on on the stablecoins. In fact, yesterday, the US Senate passed the first version of legislation getting the stablecoin on track. Very, very opposite positions of Europe and the US. Europe playing this a bit defensive game in which it feels like the biggest issue to consider is the risk of dualization through the back door.

I have to tell you both Secretary Bessent and President Trump have been pretty adamant that part of the point of this whole move was indeed dollar dominance. Donald Trump said, I have the quote, “You will unleash an explosion of economic growth, and with the dollar-backed stablecoins, you help expand the dominance of the US dollar in many years to come.” Bessent said, “GENIUS Act, the Senate bill, represents a once-in-a-generation opportunity to expand dollar dominance and US influence in financial innovation.” It is true that the US is presenting this as an effort to dominate. It’s maybe not surprising that Europe is concerned.

Beckworth: Your presentation had a great table that shows these opposite approaches. No CBDC in the US, pro-CBDC in Europe, but with these guardrails that you mentioned, they can’t be too successful. Otherwise, it undermines the banking system in Europe. This will maybe tie us into the later part of our conversation. How monetary policy actually works in Europe is somewhat different than in the US.

In the US, we don’t rely on banks as much as the ECB. In fact, I was at another conference soon after the Hoover one. We were talking about the operating systems and how the ECB is going to a demand-driven floor system. Bank of England’s demand-driven repo basically rely much more on the lending facilities to do monetary policy in the US. It’s pivotal they keep the banks functional to do monetary policy.

Garicano: The entire financial system in Europe is essentially banking intermediation. We have a very small venture capital industry. We have a relatively small private equity industry. We have a very limited private credit. In fact, even the entire private investing in equity funds in public markets is integrated mostly through banks, in some countries, up to 90-95%, with very fat commissions.

Indeed, from the perspective of monetary policy, from the perspective of sheer raw power that the banks have, and from the perspective of information, I mean the banks are the ones who do the money laundering, supervision, the tax enforcement really, the ones who follow all the payments, there is this strong, I don’t know, willingness of the state to accept arguments that say we want to keep the banks as our central conduit for policy.

Bank Regulation

Beckworth: What you just shared really helps me connect the dots in some papers I’ve read. Ulrich Bindseil, he’s a past guest of the podcast. He’s also an expert on central bank operating systems. Lately, he had been working on CBDCs. I read some of his papers in Europe. He stressed repeatedly in these papers, we’re going to restrict how much you can use it, the amount, and who gets to do it. You’ve told me now the rest of the story is they’re doing that to protect the banking system. They don’t want to have a complete wholesale run on the banking system.

Garicano: Yes. There’s always this question about the banks. You know the idea of narrow banking that John Cochrane has invented, the Chicago plan in the 1930s. I think all economists believe that more equity in financing would make a huge amount of sense for banks and that the banks are extremely risky, that having this tiny sliver of equity against this enormous balance sheet, which means that any time real estate markets or bond market sovereign, there’s a big risk in Europe of a sovereign banking loop, which is a big part of our book.

Anytime any of these risks materializes, the bank’s equity is wiped out and you suddenly get all these repair and rescue operations. We had it in the US with Silicon Valley Bank, which was invested in Treasuries and was facing this big interest rate risk when the Treasury rates increased and the price went down. We had it in Credit Suisse. Again, these are enormous bailouts. This happened upon bailout upon bailout. It’s nothing new. This happened 10 years ago. We have bigger bailouts now than during the financial crisis.

The view that the banking system is fragile and that maybe we shouldn’t be so protective of it is a view that many economists share. In Europe, one way forward is to say, “Look, we’re going to let depositors enjoy the privileges that the banks have now.” The only people with access to the reserve master account in the Federal Reserve are the banks. The only people who can access reserves in the US, in Europe, and remunerated reserves, are the banks. Why can insurance or why can the citizens not get access to the same remunerated reserves?

In a sense, what I’m saying is, yes, the regulator panics on the thought that people will move part of their deposits, or a large part, some part of their deposits to these central banks. Of course, it’s all to the stablecoins for that matter. My view is, look, on the lending side, we already have private lenders who can do equity, who can do mortgages, lenders who can do small business, lenders who can do private loans. On the deposit side, if we don’t need these things that are so fragile and all the time subject to this crisis, maybe this is not so bad. The regulator doesn’t feel that and there is partly intellectual capture.

The first time I talked to Klaus Masuch, my very first conversation after I gave a talk at the central bank in ’14 or so, we were having a discussion about capture and he was saying, “Look, when one of these premises, when Angela Merkel faces a financial crisis, she doesn’t call you or I. She calls Akerman.” He says, “What does he say? ‘Oh, of course, this is all coming to an end. You need to rescue us all and buy all our bad assets.’ What are they going to say?”

The banks are very powerful politically, very fragile. The central bank’s view on this is, “Look, we are scared of stablecoins, but we don’t want to give a big advantage to CBDC just in case.” We are living a little bit in this no man’s land, where we try to make this good enough that we stop the stablecoins, but not so good that we make the banks vulnerable.

Stablecoins

Beckworth: I like that, no man’s land, this tension between, keep out the stablecoins but do a CBDC that’s not too good and thread that needle. This is a pivotal time in stablecoin history. It’ll be interesting to look back maybe 10 years from now and see if this was when things really blew up and stablecoins took off. Because as you mentioned, just yesterday, we’re recording this June 18, yesterday, the GENIUS Act made it through the Senate. It was bipartisan. They had 18 Democrats vote along with all the Republicans. It’s likely we’re going to get this through the House. It’s likely to be one of the first things President Trump signs.

There’s been a number of reports, I’ll just summarize a few of them, that suggest rapid growth going forward in stablecoins. Citibank projects stablecoin market could reach as large as $3.7 trillion by 2030. At the upper end, the US Treasury Borrowing Advisory Committee had its quarter one report this year, and it argues it could hit $2 trillion by 2028. Then it also goes on to say, this Treasury Borrowing Advisory Committee report, that stablecoin issuers could invest $1 trillion in short-dated US Treasuries.

It’s interesting that you circle back to this dollar dominance story. All the challenges we’re having with US debt, with the trade war, all the frictions that are being created, stablecoins might be an answer over the medium to long term that offsets it. Now, I think without a doubt, the US has to get its fiscal house in order. That’s the fundamental problem. Stablecoins won’t solve that, but it does provide some relief. The fact that Europe could adopt it, other parts of the world could adopt it, that’s pretty amazing.

Garicano: Yes, it’s a gigantic potentially and quite likely significant source of demand for US Treasuries, because these stablecoins have to be fully backed by reserves one-to-one. I don’t know how many programs you’ve done on stablecoins, but let’s remind your listeners that the difference between everyday crypto and stablecoins is that these are supposed to maintain one-to-one parity and you can redeem them always at par because they’re supposed to have full backing from these liquid Treasuries or similar.

Now, in a sense, it’s like a narrow bank. In a sense, it’s like you actually have deposits that you cannot have deposit runs on, because if you just don’t like this, you just take it and these stablecoin people just sell the Treasuries and give you the money. In theory, this is a completely safe payment form. In the US, payments are very expensive through the duopoly of Mastercard and Visa. This is not as expensive in Europe. There is a very good reason. International payments are extremely expensive everywhere.

These are suddenly international payments that can be done relatively easily. Of course, the key question here is, how are we going and how is the legislation that will come out of the whole process going to enforce anti-money laundering rules? Europe is pretty strong on blocking noncompliant coins. What are you going to do with offshore stablecoins? The key stablecoin right now in the market is Tether, which is El Salvador-based.

To what extent the legislation is going to include, really, limits on offshore stablecoins operations, and that’s at the end of the day, what’s going to decide how this market is going to work because we know, let’s be all honest, that a big use case for these things has been nonkosher payments, let’s say, not just tax avoidance, but criminal or similar type payments or payments that people want to keep off the books, let’s say. Let’s not make a big judgment.

Of course, there’s also, as I was saying, a very big use case that has to do with international payments in bringing money from South Africa, bringing money from Nigeria for an international company. For example, Elon Musk has been doing this with Starlink, which allows for the transfers to eliminate all these risks.

Beckworth: As economists, Luis, we believe revealed preferences are very important. The fact that we now have a number of big US banks looking to adopt stablecoins, to me, is a sign.

Garicano: That’s a huge sign.

Beckworth: It is. They’re getting into the game. It tells me two things. One, they think it’s a big deal and they want to be a part of it because their deposit franchise could shrink, but they could offset it. Look, there are some legitimate financial stability concerns with stablecoins, but I do wonder to the extent these banks themselves get into it, it could maybe offset some of the financial stability risk. We’ll have to wait and see.

The last thing on this topic, before we get to your book, is after you gave your presentation, I went outside and I found you and a certain ECB official and some friends. We started talking about some of the amazing implications. If the worst-case scenario, let’s call it the worst-case scenario from the European perspective, best-case scenario from the American perspective, but if, in fact, dollar stablecoins dominate Europe, you know what this means for the Fed? The Fed becomes even more of a monetary hegemon, a monetary superpower. The Fed begins to effectively set monetary policy, even more so overseas. 

Then, in turn, if there is a bank-run financial crisis around the world, the Fed has to open up those dollar swap lines even quicker and offer more facilities around the world. You can flesh this story out to some pretty remarkable developments.

Garicano: Those two developments are both very interesting. On the first one, the central bank is always concerned about the transmission of their monetary policy everywhere in Europe. How does the transmission of monetary policy work in a world where people are not on euros? If they are using dollars, then whatever the European Central Bank does is not really going to matter. What’s going to matter is how is the Federal Reserve acting. That’s one concern from a European perspective and advantage from the Fed’s perspective.

On the swap lines, I am cautious and, I must say, scared in a certain sense because the gigantic extensions that the Fed has tended to do off the swap lines whenever there was a big moment of panic of liquidity crunch is part and parcel of the old international rules-based order in some sense. It’s the US being a benign hegemon. There is an aspect to which they could say, and I could imagine Trump thinking, “Look, if we’re going to do that, you’re going to have to pay for it in this way or that way.” That introduces a new source of uncertainty.

That second aspect is one where you want the hegemon to be friendly. The more you’re looking to a hegemon militarily, in trade, and everything, the more you escape, the hegemon is not necessarily wanting to be that friendly to you.

Beckworth: That’s a good point. I’ll be blunt. I hope this, too, will pass, that we’ll get past some of this. By midterm elections next year, maybe things will calm down. That’s my hope.

Garicano: Let’s see.

Beckworth: Last comment, I promise, and then we’ll move on to your book. It’s interesting, Luis, that in 2019 at Jackson Hole Meeting, Mark Carney, who was then governor of the Bank of England, proposed his synthetic hegemonic currency, and his proposal was the synthetic digital asset that was built upon a central bank digital currency asset. It’s a really fanciful, far-fetched scenario, but he proposes in response to the growth of crypto stablecoins. I think what you mentioned earlier, the proposal for libra, I think, really scared a lot of central bankers, him, ECB president. We see CBDC conversations take off as soon as Facebook announces libra, right?

Garicano: Totally, that is the moment. I agree.

Beckworth: Now it’s coming back full circle. It might be the case that we have, instead of a synthetic hegemonic currency, instead of a CBDC, we’re going to actually end up back at a place where we have these private stablecoins, and of course, backed by US dollar assets. Super fascinating development. In fact, I just saw in the news recently, Amazon, I think Walmart, are looking at stablecoins. Now, my understanding is that’s not possible under the current legislation, but private merchants are looking at this.

Garicano: This is one of the places where the legislation and the legislative developments are going to be more important. What is going to happen with nonfinancial issuers? To what extent are they going to be allowed? What happens to conglomerates and larger issuers? In the US right now, there are stricter requirements for the largest issuers. There are restrictions on nonbanks right now. My expectation is that the legislation will not allow nonbanks.

You could be Walmart, you could try to get from the Fed a banking license. I actually don’t know. Some of these players could get a banking license, and then use it to issue. Yes, I would imagine there is going to be very, very much interest in many players in this, and I would expect, at least in the US, a very big growth. In Europe, as I was saying, both from the legislative perspective, the regulatory perspective, there’s a little bit less of an impulse. Will we adopt stablecoins? Let me just give some caveats because I do tell people there is concern in Europe.

The truth of the matter is, from the perspective of a European citizen, is there a real need to? What is the pull or the push to get dollar-denominated stablecoins? You’re also engaging in some currency risk as a citizen. Do you want to carry currency risk? Do you want to get dollar-denominated stablecoins, or you’re a euro payer most of the time?

There are advantages for the crypto users. It’s a good natural way to go back and forth to crypto, so they might want to use it. There are these early use cases, as I was saying, like international trade, Elon Musk’s SpaceX, for Starlink, Scale AI. There are users which could seep into the economy. Then, of course, you get the network effects. There is clearly a doubt that this will happen. This is a risk, and since the cost of a risk for Europe is big, people are concerned. It’s not clear that Europeans will rush to adopt this.

Crisis Cycle

Beckworth: Okay. Let’s transition into your new book. It just came out. You’re the co-author. Again, the title is Crisis Cycle: Challenges, Evolution, and Future of the Euro. We encourage listeners to go get their copy. We’ll provide a link in the transcript and show notes. Luis would love for you to get a copy of his new book.

Now, Luis, what’s interesting to me about this book, and I was excited to read it, is that one of your co-authors is John Cochrane, big advocate of fiscal theory of the price level. I’ve always wrestled with how do you think about the eurozone in the context of a consolidated government budget constraint, where you combine the central bank and the Treasuries. You have one equation that shows on one side government expenditures, government revenues on the other. One of the things on the revenue side is money creation. In theory, the ECB doesn’t have that. Your whole book answers this question. You work through how this has evolved over time. How did the three of you get together in the first place to come up with this book?

Garicano: That’s interesting because we are three very, very different people with very different profiles. Klaus Masuch was an official, he retired in December, of the European Central Bank, a very high official. He was in the very early stages with the European Monetary Institute in the ’90s, the precursor of the euro, and he’s gone all the way to 2024, so he’s seen it all. For example, just to give you an example, he’s been the manager of the troika for the European Central Bank, the Greek and Irish rescue. He is somebody who’s seen that from the inside.

Then John Cochrane, who is indeed one of the foremost asset pricing and indeed the foremost fiscal theory person. I’ve been doing politics and policy. I am, let’s say, a Chicago price theory person, a Baker, Rosen, Murphy student, who’s worked mostly on productivity and growth and information technology and all of that. I got very involved in euro crisis and did a lot of work on what was wrong with the euro crisis.

Then in politics, all my time in politics, I was the vice president for economic affairs, interrogating Lagarde and everything. I come more from the policy side to this. I was talking to John about this in the conference, and I was talking to Klaus. I had this idea for the book, and I thought, “Okay, this is the perfect trio.” I know exactly what’s been going on in policy. Klaus knows exactly what are the details of how the bank took decisions they took, and John knows everything about the theory.

Basically, think of it as drugs. The European patient is sick, and he gets all these doses of morphine, and the morphine is necessary. The book acknowledges that the morphine was necessary. The European Central Bank did have to expand its balance sheet, did have to do certain things in 2008, 2012. QE was necessary then, and even some rescues of the banks were necessary with ECB support.

What happens is, like the patient who gets morphine, the European economy gets used to this, and they blur, as you were pointing out, David, the boundary between the monetary and the fiscal policies. The fiscal-monetary boundary gets completely blurred. The governments become addicted to these big operations. I think the European Central Bank, the Bank of England, and the Fed, everybody made this, in my opinion—and I don’t speak for my co-authors here—this gigantic mistake, but I think they will share this, with the rounds of QE that took place in the second half of the 2010s.

We are just a little bit below where we should be on inflation. Then we make these gigantic operations that basically mean that we’re financing monetarily the fiscal deficits of all these countries. We find ourselves in a situation where basically nobody has any incentive. It’s collective moral hazard, as Farhi and Tirole called it. Nobody has any incentive to do the institutional reforms, which are painful, to get the growth reforms that are necessary, to get the fiscal houses in order, or to actually stop this addiction from easy money that has been created with these operations.

Beckworth: I loved your book because it really traced the history of all these developments and how they kept pushing back what was acceptable, the boundaries. You start this story off as early as, I think it’s 2003, when France and Germany violated the budget laws and they went above. Because they were the biggest kids in the block, they could say, “Ah, the rules don’t apply to us.” That was pivotal in terms of credibility, right?

Garicano: Yes, exactly. Because the founders were very aware of the risks of fiscal and monetary blurring, what they did is they put certain fiscal rules and said, “Look, we’re not going to have any problem because no country will need to be bailed out by the monetary authorities because nobody’s going to have excessive debt.’ We said, “Limit on debt, 60%. Limits of deficits, 3%. We’re going to just not ever get in trouble.”

Now, the first countries that ignore this are Germany and France, who are the key countries in the eurozone. The European Commission starts the process and, we tell the detail in the book, starts digging. Then at some point, the countries said, “No, we don’t like this. We’re going to stop this operation. It’s not going to happen,” which gives a very clear signal to the other countries, which is, “Well, you know what? This discipline from the fiscal authorities is not going to exist. Let’s ignore it as long as we can borrow in the market.”

Now, the market discipline, the bond vigilantes, didn’t really operate either in that decade because they thought, “Well, these guys are in a monetary union, they will take care of each other.” In some sense, they were expecting us to do the opposite of what we were promising to do, which is to rescue each other. Now, indeed, the crisis comes, and that’s what we do. We rescue each other.

Then the discipline really goes by the wayside because all of these promises, the triple lock of we’re going to have all these locks against monetary financing from the bank, against debts, against rescues, all these things proved not to exist. They create this situation where governments believe that they can count on this monetary support. That’s the risk.

Beckworth: Yes. You tell this story. There’s this credibility shock or credibility deterioration in 2003, 2004. Then you talk about the Global Financial Crisis in 2008, 2009. Then there’s the sovereign debt crisis in 2010, 2012. Then a lot of things happen in the eurozone between that. Then, of course, then there’s the most recent development of COVID.

Garicano: Let me summarize that first bit that you mentioned, because I think it might be interesting for the listeners. An interesting moment in the financial crisis that we discuss in the book is when Ireland decides to guarantee all the deposits in the Irish financial system. That obviously wasn’t possible for the Irish state because the financial system was enormous. It was counting on somebody supporting it, the emergency liquidity assistance instruments, which were put in place by the central bank.

Basically, the governments, either the ones who were solvent but just were rescuing the banks or the ones who were in trouble, like the Greek governments, they were all counting on the structure of financial guarantees to go forward. Now, it’s not a history of everything deteriorating. There are three periods. There’s a moment where things get worse, which is the financial crisis, and all these rescues. There is a moment when Europe says, “Hey, what we did is wrong. We need to get this right.” There was a 50% haircut on the Greek debt, which is good. Within the eurozone, we need a default process. That was good.

There is a system of bailouts that was put in place at the same time as Draghi said, whatever it takes, which is like IMF. We’re going to ensure there’s fiscal backing and fiscal discipline, not monetary. There is this moment of hope of we’re going to get our house in order. Then the QE comes in, and then as you said, the COVID and the pandemic, and everything becomes like, okay, everything goes. Now we find ourselves in a situation where we have this delicate construction. Nobody wants to touch it because it’s built of all these exceptions. The truth of the matter is, I don’t think it’s a sustainable situation.

Beckworth: Now, going back to the very origins of the ECB, and to give them credit, and we touched on this earlier, the original way the ECB was set up is it would grow the asset side of its balance sheet through lending. It wouldn’t actually buy government bonds.

Garicano: Absolutely.

Beckworth: It was all bank lending, which, again, speaks to the structure of the financial system in Europe. Of course, that changed when they had to do all these QE and other monetary actions during the different crises. Now, they have started a journey to return, as I understand it, to something where they have a much smaller balance sheet, and they want to rely more extensively on those lending facilities, again, to grow the asset, the size of the balance sheet.

Again, they call it a demand-driven floor system. I think a better term in the limit, if they push us to be a demand-driven ceiling system because the lending rates would determine stuff. Do you think this journey is sustainable? Can they actually get there? Is it the right direction?

Garicano: There are some things that make me question whether it’s going to be sustainable. Let me tell you two. One is they’ve done pretty well on undoing the support to the banks, but the support to the sovereigns is still very massive. There is still a very large player on the sovereign market, and they’re doing this very, very, very slowly. The second is, in the new operation framework you were referring to, there is a lot from the crisis that stays over, a lot of strange things.

Initially, the lending to the banks is against good collateral. That’s what it should have been. During the crisis times, you say, “You know what, I’m going to allow you to post poor collateral, and that’s going to be all right because we are in a crisis.” The actual operational framework that was approved last year allows the continuation of the nonmarketable collateral posting in order to get financing. I think that from a monetary perspective, that’s not kosher. I think this is distorting incentives and financing. A bank which has a poorer balance sheet should be getting more expensive financing in order to give them the right incentives to actually give the right loans and to monitor the loans.

I am not sure if we are putting in place a sustainable and stable operational framework that is going to actually allow us to go back. Remember, even after the first round of rescues and all of that, the balance sheet of the European Central Bank was a meagre $0.4 trillion. By the standards of what it is now, it was a pretty reasonable-sized balance sheet. It’s 10 times bigger during the crisis, and it’s still now like nine times bigger.

It is very difficult to little by little go back to the normal. We’re seeing it with the Bank of Japan, where, even today, they are actually positive net buyers of Japanese debt with inflation higher, with interest rates. There is really no reason, all the QE rationales, which were inflation or crisis, they’re wrong. The only reason they’re buying debt is because they are supporting the fiscal budget. There is no other question, I’d say. This is the theme of the book, undoing this unconventional monetary policy, which really, at some point, stopped being monetary policy and started being monetary financing, in my view, is a really difficult path for the central banks.

Beckworth: So many questions this raises for me. Again, it’s a real treat to have you on, because you were in the European Parliament during some of these crises, so you got to see things firsthand as well. Let me ask this question, and then I want to go back to maybe the origin story. You guys make a great point, that the way the ECB was set up, it didn’t have all these contingencies in mind. That’s part of your reform package to make it more robust.

Let me start with this. When we do try to shrink central bank balance sheets, this is true everywhere, we start this journey, and in some places it’s easier than others, but inevitably there’s going to be the next shock, the next recession, the next crisis, which may cause the balance sheet to go up even more.

I think part of the challenge is we don’t have enough normal time or easy time between the last crisis. That’s going to be difficult. The other point I want to make is more of a question to your experience. The resilience of the eurozone is what really amazes me, particularly after the eurozone debt crisis. There was a lot of talk when Greece was at the bottom—the economy was really bad, unemployment high—there was talk of Greece leaving the eurozone. There was talk of it breaking up because of the amount of pain. The one-size-fits-all monetary policy didn’t make sense.

It wasn’t an optimal currency area, all this discussion. Yet here it is. It’s still with us today. Apparently, the love, the desire for the euro is so strong that Europeans are willing to tolerate it, even if it’s not optimal monetary policy for every part of the eurozone. Help us understand this resiliency. Yes, there are challenges you bring up in the book. Man, it’s remarkable that it has persisted through this crisis.

Garicano: Yes, it is true. That moment was a very tricky moment. I don’t know if your listeners are aware indeed, as you were saying, that there was actually a decision from the finance ministers to stop their financial assistance to let Greece drop out of the euro. The decision, in contrary, against the recommendation of the finance minister at the time, who was Mr. Schäuble, a German finance minister, very pro-European but very firm, very Germanic type, was made by Merkel. She made it strictly for political reasons. I think what economists in your side of the Atlantic tend to miss, is how much of the euro is a political project. There is definitely a love, as you were pointing out, by the citizens that they have a currency that is solid and citizens like solid currencies.

There is a political project in Europe that goes way beyond that love and that usefulness, that if you go back to the origins, as you were suggesting we do, when was the euro created? The euro was created when German unification happens. The Germans were very proud of the Deutschemark and in no circumstance they want to give up the Deutschemark. Then Eastern Europe, the wall collapses. Eastern Europe merges into Western Germany. In order to get Mitterrand, to get the rest of Europe, not just the French but everybody else, to accept this, the Germans accept giving up their currency. Now, this is 1992. The Maastricht Treaty. It’s a political bargain.

We’re going to all get a strong currency in exchange for accepting Germany. Essentially, it’s about anchoring Germany down into Europe. It’s the same as NATO. NATO was always about making sure that Germany was part of the European defense and there was not this big German army that was threatening Europe again. The American schooling there was crucial. The decision to keep Greece in, I think, is a decision for the ages. I think that Europeans will do and will always do whatever it takes to keep the euro. It has been costly in many moments.

The euro crisis was very costly for the European periphery. It’s very likely that if it had been just an arrangement of fixed parities, Spain and Greece would have devalued and we would have got growth, at least in the new currency terms. We were in a fixed, common currency and there was a political decision. Which, I think, makes sense when you think of euro history. We have a history of being at each other’s throats. The single markets and the euro are two ways that European politicians have promised each other nobody fights against another side for which he has this buy-in. At least that’s the hope.

Beckworth: Yes. I think the big takeaway for me as an outside observer on the other side of the Atlantic, as you would say, is that fact that Greece is still in the European monetary project. The fact that you guys all stayed together through something as trying as the debt crisis, that’s a big credibility signal. That signals to us this is not going away. This has persisted. They’re willing to suffer. To preserve the currency union. That’s what I call a credibility signal. Markets believe, I believe, we all believe the euro is going to be here for a long time.

Garicano: Imagine the worst-case scenario, which is the person who wins the election wins on the basis that they’re not going to take it anymore. They do a referendum in which the voters reaffirm that they’re not going to take it anymore, which is Tsípras and Syriza, a very extreme left party. In spite of all that, this person turns around, Tsípras, and says, “You know what? Yes, we want the euro. We’re going to do whatever pain we need to do.”

Beckworth: Yes, it’s an amazing turnaround. Good for the euro project. Okay, so let’s go back to the origins. I guess the question I want to ask is what were the flaws in the original design that you’re trying to ask? This is not something you argue in the book, but some people say the original flaw was they included Greece in the project. You and your co-authors argue more about how do you handle crisis, debt issues and stuff. Walk us through your vision of what the original design flaws were.

Garicano: The key design flaw is wishful thinking on the sovereign. It’s like, “Oh, we put these rules. Since we have a rule that you cannot speed too fast, we don’t have to make cars that resist 200 per hour speeds because nobody will speed.” It’s like, “No, people will speed even though there is a rule.” We put these rules. We assume away bankruptcy. We assume away insolvency. We assumed away the possibility that somebody would actually face a situation where they were insolvent. Now, once this happened, we didn’t have an IMF way to actually restructure and give people credit and give people bridge loans and so on.

We didn’t have a bankruptcy procedure. What we are thinking is, “Look, guys, right now, the way we’re papering over this is by having the European Central Bank extend promises of being behind delinquent countries.” This is the transmission protection instrument, which has the weirdest name in the world because it’s nothing to do with transmission and all to do with sovereign yields going out of whack. Remember, it was created after Christine Lagarde said, “It’s not our problem. We’re not there to mind the spreads.” It turns out there is not just the average, but the spreads that they care about.

Our recipes have to do with facing the music, accepting that this is going to happen, and making sure the system is robust to accept it. Let me give you a US example. I spent 15 years in the University of Chicago, which I adore, and I adore the city of Chicago. The truth of the matter is, the city of Chicago is extremely responsible and keeps promising the firemen and the teachers that it’s going to pay them these unpayable pensions. The state of Illinois, seemingly responsible now, is it the expectation of the US citizens that Chicago will have to exit the dollar when it comes out that it cannot pay the pension of these policemen and teachers? No. Sorry.

The bondholders, the holders of the money bonds, will actually have to suffer. There will be a restructuring. The holders of pension rights, the implicit promises that Illinois made, are going to have to be cut down. That doesn’t mean Illinois or Chicago are going out of the dollar. It means we have to have a process for that. This has happened in the US: Kansas had a sovereign restructuring, and it has happened more times. I’m afraid, knowing Illinois and being an honorary Chicagoian like I am, I’m afraid that will happen in Chicago. What we want is something like that.

It’s the acknowledgment that countries can go through trouble, that the discipline has to apply to the markets, but that doesn’t mean that the dollar is going to blow up. That means an IMF-like instrument, which is the European Financial Institute that we propose as monitoring and the ability to extend fiscal support, not monetary support. We want the monetary authorities out. Crucially, cutting the sovereign bank loop, which is still very strong in Europe, to continue my analogy, the big holder of monies from Illinois in Europe and from Chicago would be the banks in Illinois. Which is a disaster because then it goes down, the banks go down, and because the deposit insurance in Europe would be the city of Chicago, people who would be guaranteeing those deposits imagine the mess. We need to stop that. We need deposit insurance which is European. We need the banks to be diversified and to hold portfolios that are diversified, not concentrated in our countries. We need a bankruptcy procedure for Europe, and we need this European Financial Institute that runs all these things. 

We don’t want to make default normal. Default is always a problem, but we want to make default something that is conceivable without putting into question anything about the euro and about the currency. In the current situation, that is not the case because of the tight linkage between the banks and the sovereigns, and because of these very large levels of debts that go way beyond what the founders of these treaties proposed.

Beckworth: Let’s flesh out your proposal here for this bankruptcy process. You gave the example of Chicago. There’s bankruptcy laws in the US that make this not pleasant, but it works out, and we can do it. We can make it happen. What would it take to get some bankruptcy law for a sovereign to sort out its debt to make your proposal work?

Garicano: I don’t think it’s anything very complicated in terms of the actual steady state. We did a sovereign debt restructuring in Greece. There was a big American lawyer, Lee Buchheit, who worked on these procedures, and this has happened internationally. Other times, you basically change maturities, you do exchanges, you try to get the greatest degree, you do all these things. The problem, of course, the big problem that people see in this is the transition. You go from a situation where people understand all sovereign debt is safe assets, and we have zero risk weights, whether you hold Greece or Germany—all this can be held by the banks—to a situation where we have to acknowledge this risk exists and who’s going to buy. 

Are we going to have to pay more? Is that going to engender instability? I think we are very mindful that our situation of transition requires support and it has to be done little by little. We also think that this cannot be the steady state. The situation where we assume away a problem, this cannot happen. As you said, when we started this part of the conversation, in Japan or in the US, it’s very clear. Either at some point you raise the taxes to pay this or you default or you have hyperinflation. This makes things very transparent to taxpayers who understand that at some point, these things don’t add up.

In Europe, there is no default process within the euro. Then you come back with a re-denomination risk, is this country going to exceed the euro? Why is the re-denomination risk so important? If you exceed the euro, it’s not a problem for Chicago. It’s a problem for the businesses which are based in Chicago. It’s not a problem for Greece, but it’s a problem for every shipping company in Greece, every food company, every person who has a loan that is denominated in euros. All of that is at risk. We don’t want that re-denomination risk under any circumstances. We don’t want this risk to be hidden under the carpet. We want it to be dealt with in an orderly process.

Beckworth: If I use again the US as an example, there’s New York state laws, a lot of contracts are issued in New York City. You have one set of laws applies to all. You may be from Chicago, wherever, or maybe it’s federal statutes. If I’m trying to take that principle, apply it to Europe, would this require the European Union parliament? Would you want a common law for bankruptcy applied across the union and then who would legislate it?

Garicano: Yes. This is a great question. Let me talk about private bankruptcy first for a second. Private bankruptcy is one of the most important institutions of the capitalist system because you made the loss. You have to find a way to distribute those losses and to see who’s going to carry it forward. The private bankruptcy systems in Europe are very diverse and they are not harmonized. Any system that right now a bank goes under, for example, in Italy, they have very high priority for the bank employees. Those have seniority vis-a-vis almost all creditors.

If you want to change and harmonize bankruptcy law for banks in Europe, that is already a mess because this tiny precedence thing that I’m mentioning, which is the bank employees in Italy are going to strike if they are pushed down in the order of who’s going to be paid first behind some creditors. When you talk about the sovereigns, indeed, as you’re very well hinting, that cannot go. Different sovereigns are going to have different thread points depending on how is this law—it’s all national law. It’s all sovereign immunity. You’re a sovereign. You can say, “Look, I’m going to change these rules because I say so.”

We have started introducing all of these collective auction clauses in the contracts that try to facilitate this restructuring. I would hope that there would be harmonized European legislation that would deal with this and that would provide this orderly procedure. I would say most people would agree that’s a desirable steady state. Where people would have the trouble is with the quote about in the long run, we are all dead. How do we deal with the short, medium run? Which is a place where we go from everything’s guaranteed, nothing can happen to, yes, we assume there are risks and countries have to be willing to deal with this risk and to issue debt that is consistent with this risk.

That part is the one that I think divides different people. We believe, “Look, that might be difficult, but we have to start facing the music.” Others believe, “Well, let’s look at that after the next crisis.” As we say in the book, Europe has gone through four once-in-a-century crises in 15 years. We’ve gone through the 2008 crisis, the sovereign debt crisis that you mentioned, 2010, ’12, the pandemic, and the Ukraine war. Those are all zero probability events in some sense. That happened four times. We say, “Look, you cannot act as if these things don’t happen. These things happen. You have to put your house in order and use these moments when things are better to try to get your house in order.” 

At the end of the day, the most important thing to getting the house in order, and let me finish on this note, is growth. Europe is not growing. We have too many rules. We say in the book, the kinds of things we’re talking about are not going to increase the growth of Europe. They’re going to put the conditions for other reforms where growth happens. At the moment, because Europe is in this suspended state on drugs, as I was saying, nobody’s really taking the difficult actions. The important things are the pro-growth reforms that Europe desperately needs.

Beckworth: All right. We need pro-growth reforms. We need better bankruptcy laws. In the few minutes we have left, what else would you want to leave with the listeners? What other reforms do we need to push through to make the euro a long-term viable project?

Garicano: Christine Lagarde wrote about the euro’s chance now that the dollar is under attack from the inside, from the government of the United States to some extent by putting into question certain obligations. I would like the euro to be able to become a global currency. I think two things are necessary. First, we need strong institutions that are credible. You’re right that the political credibility of the project has significantly increased with the crisis when many people thought we couldn’t go forward, and we did. 

The institutional reforms that we promised, we said we were going to do a banking union. Deposit insurance would be a European affair. That didn’t happen, and the sovereign bank loop is still not cut. The deposit insurance at the European level is a crucial reform. It’s not possible to have Spain be responsible for the bailout of the Spanish banks when the Spanish banks are in trouble, potentially because Spain is in trouble, because this vicious circle sinks both. 

The banking deposit insurance has to be done at the European level. In the US, that’s done, there’s the Federal Deposit Insurance Corporation. We need something like that. We have a germ of that with a Single Resolution Board and a Single Resolution Fund, but it’s not strong enough to do the deposit insurance. As I was saying, and that’s my second point, is the institutions. My second point is the crucial one. Europe needs to grow again. The salaries in Spain and the productivity have basically stagnated since the financial crisis, or even before that. The ones in Italy have basically stagnated since 1995.

Beckworth: Wow.

Garicano: We have a continent that is growing older, that has increasing demands on our welfare safety net because of the aging population. At the same time, an aging population doesn’t want to change anything because it wants things to continue. They love the way things are, and they don’t want to change anything. We have a young generation which is getting squeezed, and we need to give people chances. That means the market has to work, and the rules have to be weakened. We’ve passed, in the European Parliament and in the European Council, a huge set of rules that are making it very difficult to do AI, to do digitalization, to scale up companies, to get firm-sized growth.

I wrote a paper in the American Economic Review with John van Reenen on the limits to the growth of European firms. We show that when you get to 50 employees in France, you don’t want to grow over 50, because at 50, you need to get all of these new rules and trade unions and the extra payments. These types of things, allowing firms to grow and to scale up in the European single market, that has to be the single-minded priority of Europe. If we really want to grow the euro into a single currency, we have to have an economy that can support this welfare state and all of these demands.

Beckworth: With that, our time is up. Our guest today has been Luis Garicano. His book is Crisis Cycle: Challenges, Evolution, and Future of the Euro. Be sure to get your copy. Luis, thank you for coming on the program.

Garicano: Thanks very much. It was my pleasure. We had a great conversation. I really enjoyed it. I hope your listeners enjoyed it as well. And yes, buy the book.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you liked this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth and follow the show at @Macro_Musings.