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Europe’s Next Financial Crisis Could Be the Big One
The EU’s failure to reform after emergencies has left the euro vulnerable.
- By
- July 24, 2025
- CBR - Public Policy
A common currency is a wise and important component of European integration and economic vitality. The euro was set up presciently, but its evolution in a sequence of crises now leaves it in a vulnerable state. It needs fundamental reforms to survive and prosper. Crisis Cycle: Challenges, Evolution, and Future of the Euro, my book with London School of Economics’ Luis Garicano and Klaus Masuch, formerly of the European Central Bank, tells this story and recommends reforms.
A monetary union without fiscal union leads to an obvious temptation: Member states might borrow and spend more than they can repay, and then call on the central bank for a bailout using newly printed money. The architects of the euro understood this danger well. They designed an independent European Central Bank, whose mandate is exclusively price stability. The ECB did not buy sovereign debt. Countries were to follow debt and deficit limits. The countries of the union also committed against fiscal bailouts.
But the founders left a few bits unfinished. In a currency union without fiscal union, overindebted countries must, in extreme circumstances, default—just as companies do. The euro founders couldn’t quite say this. They made no provision for sovereign default, and no crisis mechanisms to help sovereigns stave off default. Banks were and continue to be allowed to treat sovereign debt as risk free, which encourages its holding but means that sovereign default imperils banks.
These omissions are understandable. Nobody in the 1990s foresaw advanced-country sovereign-debt problems or a financial crisis. One does not write every contingency in a founding document, as one might not negotiate a prenuptial agreement too harshly the day before the wedding. One naturally expects that a founding document will evolve and be elaborated upon over time. Yet that continuing reform has stagnated.
In 2003, less than five years after the euro was established, France and Germany breached the debt and deficit limits, without repercussion. In the financial crisis, the ECB began to lend much more freely to banks, against riskier collateral including sovereign debt, thereby further encouraging banks to buy that debt. The ECB began, unintentionally, to finance a large share of countries’ balance of payments deficits by allowing countries to maintain negative balances with the EU’s TARGET2 payment system. Countries paid for imported goods with debts to the ECB.
The next crisis will challenge European sovereign debts. That crisis may be bigger than even the ECB can handle without chaotic defaults, financial meltdown, or sharp inflation.
The 2010 sovereign debt crisis was the earthquake. The ECB, feeling it was the only game in town, intervened on a large scale, including making large sovereign-bond purchases and lending to banks to fund their sovereign-bond purchases. Then-ECB president Mario Draghi famously pledged “whatever it takes.”
Eventually, an adjustment-program mechanism emerged, allowing support with conditionality and imposing some losses on some creditors. But this institutional reform later fell from grace, and has been crowded out by other ECB interventions starting in the early 2020s. Self-imposed rules on bond purchases weakened with each new intervention.
Bond buying in the quantitative-easing era further enlarged the ECB’s sovereign bond holdings, and surged during and after the COVID-19 pandemic. The ECB introduced “flexibility” in purchases to keep sovereign spreads from rising. Inflation climbed sharply starting in 2021 while the ECB continued bond purchases and kept rates low. That surge undermined confidence that the bank could and would control inflation, making any future crisis more unstable.
So here we are. Europe is in a fragile state. Overregulation and bureaucracy stifle innovation and growth. Member states’ debts have risen dramatically. The ECB holds large portfolios of sovereign bonds, and is widely expected to buy more anytime yields or spreads threaten to rise. Banks remain stuffed with sovereign debt, so any sovereign crisis becomes a bank crisis.
The next crisis will challenge European sovereign debts. That crisis may be bigger than even the ECB can handle without chaotic defaults, financial meltdown, or sharp inflation.
Most of all, Europe is suffused with moral hazard. The incentives for governments to tax and spend wisely, reduce debts, and pursue growth-oriented economic reforms are much reduced. The incentives for investors to evaluate and monitor sovereign risks, and to shift those risks out of highly leveraged banks, are reduced.
The central problem does not lie in the ECB’s actions in crises. The problem lies in the failure of member states and European institutions to reform after each crisis so the ECB does not feel the need to jump in once again.
We suggest a series of reforms to address these concerns:
- There must be a European fiscal institution that can quickly offer support, subject to conditionality, to help member states in trouble, allowing the ECB to avoid that inherently political and fiscal task. Sovereign default must remain a possibility, however, or the fiscal institution has no leverage.
- Banks and their regulators must treat sovereign debt as risky, they must hold less sovereign debt, and the debt they hold must be in more diversified portfolios.
- Sovereign debt must be in hands that can bear risk. Completion of a European banking union is an important step toward that goal.
- The ECB must reduce its sovereign bond portfolio, its lending against weak collateral, and its aversion to letting any sovereign spread rise.
Europe needs growth. One prerequisite is having a common currency, a central bank, a banking system, and a financial system that do not incentivize fragility and can withstand the next shock, as the euro’s founders envisioned.
John H. Cochrane is a senior fellow of the Hoover Institution at Stanford and was previously a professor of finance at Chicago Booth. This essay is an adaptation of posts on The Grumpy Economist Substack and the London School of Economics’ European Politics and Policy blog.
Crisis Cycle: Challenges, Evolution, and Future of the Euro was published in June by Princeton University Press.
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