United we stand, divided we fall: an economic explanation of why a divided Europe cannot overcome the crisis

by Eleonora Alabrese, Antonio Bosisio, Matteo Roberto Greco, Filippo Torricelli and Valeria Zurla

student group at Università Commerciale Luigi Bocconi
Supervisor: Asst. Prof. Italo Colantone

Abstract: Europe is at a turning point. The crisis that hit it had significant adverse economic, social and political consequences. However, after almost a decade, many European countries are still struggling to recover. As a consequence, a sentiment of mistrust towards the European institutions, held responsible for not providing a definitive answer to the crisis, is arising among many European citizens. The goal of this work is to explain the reasons that lie behind the current economic and political situation, and eventually to propose an effective way to resolve the crisis. We will argue that it is only through an intensification of the integration process that Europe can exit the deadlock it has reached in recent years and face the future challenges.

For seven years now, the word “crisis” has constantly been at the centre of our everyday lives. When did it start? What has been done so far? Why haven’t we overcome it yet? Our aim is to answer these questions and to explain why Europe is today at a turning point from an economic, social and political perspective.

Breaching the system: an outline of the financial crisis

First of all, it is worth explaining briefly how the financial crisis originated in the United States and then spread to Europe. Prior to 2005, a prolonged period of low interest rates made investments in real estate much more attractive than financial products: households could take out a mortgage at a low interest rate and purchase a house, the value of which was expected to rise almost indefinitely. Investment banks and financial institutions
began to purchase these mortgages and consolidate them into financial instruments known as collateralized debt obligations (CDOs). However, as the demand for this kind of investment increased, banks began to grant mortgages to riskier individuals at worse terms, the well-known subprime mortgages.

When in 2005 the US Federal Reserve started raising interest rates, the cost of taking out a mortgage increased. Simultaneously, the rising number of defaults on residential mortgages caused excess supply on the housing market. As a consequence, house prices plummeted and the bubble exploded. Investment banks and financial intermediaries holding considerable numbers of defaulting CDOs stopped trading with one another and began hoarding cash because of the lack of information on the quality of CDOs. This contraction in the interbank market and the collapse of balance sheet asset values of several banks resulted first in a liquidity crisis and eventually in a solvency crisis.

From financial crisis to sovereign debt crisis: emergency measures and austerity policies

As the European banking system is the biggest in the world (51% of world bank assets in 2008), it was not exempt from purchasing CDOs and derivatives and Europe could not avoid being affected. As a consequence, both the European Central Bank (ECB) and the national governments intervened in this emergency situation.

The ECB, in coordination with other non-European central banks, implemented monetary stimulus accounting for a greater than 3% decrease in interest rates. The aim was increasing liquidity in the financial system, in order to respond to the halt of the interbank market.

The governments tried to break the chain of negative events in two ways: first, through the implementation of fiscal stimulus (lower taxes and increased public spending) to boost the real economy (namely the part of the economy that is concerned with actually producing goods and services, as opposed to that concerned with trading on financial markets) and limit contagion; second, through the rescue of the banking system using instruments such as recapitalisations, loans and deposit guarantee.

However, this second operation was problematic since the last twenty years have seen an enlargement in the scale of European banks that went well beyond national borders. Thus, in the absence of a central fiscal policy, each state was forced to refinance banks which were formally national but European in size.

The situation just described generated a peculiar link between the banking system and national sovereign debts, the so-called negative feedback loop (European Commission 2011), which de facto transformed the financial crisis into a sovereign debt one:

  1. The debt/GDP ratio rises as a consequence of the previously described fiscal policies (↑debt) and of the recession caused by the crisis (↓GDP). The perception of risk of public debt unsustainability increases. This in turn has a negative impact on the banking system itself, since each bank’s balance sheet bears a substantial share of sovereign bonds losing value.
  2. In order to recover their financial stability, banks are forced to deleverage their assets and/or increase interest rates on loans. This makes it more difficult for households and firms to access credit (credit crunch), which in turn exacerbates negative effects on the real economy.
  3. The further reduction in GDP clearly impacts the debt/GDP indicator, thus self-reinforcing the crisis. Hence, the situation deteriorates even more and the loop starts again.

In addition, the excessive scale of current account deficits (which are a measurement of a country’s international trade where the value of imported goods and services exceeds the value of exports) in Europe’s periphery during the pre-crisis period contributed to the severity of the economic contraction through a sudden stop in capital flows and damaged banking systems as well as sovereign creditworthiness (Belkin et al. 2012).

Member states were finally aware that solidarity was an inescapable step to recovery.

From late 2009 on, fears of sovereign defaults grew publicly while government debt of several states was downgraded. The crisis first hit Greece, Ireland and Portugal, while raising concerns about Italy and Spain as well.

What measures were introduced in order to break the loop and manage the renewed emergency? In brief, member states were finally aware that solidarity was an inescapable step to recovery. Therefore, from early 2010 they contributed to huge funds (European System of Financial Supervision, European Stability Mechanism) in order to support the most affected countries, while the ECB started unprecedented monetary operations in order to alleviate their financial burden. What is the flip side of the coin? This increased solidarity between countries came together with greater national fiscal commitments, the so-called austerity measures (e.g. Fiscal Compact, European Semester).

Impact on the real ecomony: unemployment, poverty and inequality

What were the main consequences on the real economy? Today, the social and economic condition of the eurozone is still depressed and fragile, as shown by key macroeconomic indicators: growth did not exceed 0.8% in 2014 after two consecutive years of recession, remaining below its pre-crisis level and far from its potential; especially in poorer states, growth rates have declined more than in relatively richer ones.

As a consequence, unemployment skyrocketed: there is a profound divide between some countries dramatically facing unprecedented levels of unemployment and others remaining relatively unaffected, with the worst conditions prevailing for Greeks and Spaniards under the age of 25 (unemployment rates reached peaks above 55% for this category).

In addition, inequality and the risk of poverty increased significantly. As far as the former is concerned, if one considers the EU28 level, the Gini coefficient, which is the most commonly used measure of income disparity (it ranges between 0 and 1, with higher levels denoting increasing inequality) shows a very high level of inequality (though not so different from the US) which increases slightly from 2009 onwards. However, such a high value is mainly driven by the relatively poorer Eastern European countries which recently joined the EU (the level of inequality diminishes when restricting the analysis only to eurozone members). Still, a rising trend in the global level of inequality exists and cannot be ignored. The risk of poverty, measured by the at-risk-of-poverty (AROP) composite indicator (i.e. the share of people whose income is below the AROP threshold, set by the EU at 60% of the national median disposable income) has risen significantly, especially in most southern and eastern European countries.

The eurosceptic union

Rising inequality and the call for austerity policies led to one of the most threatening drawbacks of the crisis for Europe as a whole, namely the upsurge of frustration and discontent towards the euro that resulted in the creation of eurosceptic and anti-austerity movements (The Economist 2014).

These political movements are present in almost all European countries, gaining consensus without the need for any clear ideology while seizing upon heartfelt issues and proposing populist, often unfeasible solutions (Kassam 2014). They all share the grievance that Brussels is dictating people’s lives and their views on European issues. The European Parliament (EP), until now a bastion of European federalism, is becoming a centre for all sorts of anti-Europeans, with anti-establishment parties controlling nearly one third of the seats. For once, after the last elections, European leaders seemed to agree: the union must change, and fast.

Should we exit EU’s Economic and Monetary Union (EMU)?

First of all, what are the main claims these movements share on European issues? For simplicity we focus on two Italian parties (the Five Star Movement and Lega Nord), which we find representative of the family of anti-austerity movements.

  1. Exit EMU now;
  2. Stop the European integration process;
  3. Abolish the Fiscal Compact;
  4. Give countries sovereignty on defence, foreign politics, fiscal issues, fundamental rights and any other issues at their discretion, but
  5. Give more power to the EP;
  6. Yes to Eurobonds.

In spite of the lack of internal coherence of their proposals, these two movements agree on the fact that Italy should exit EMU. Why? The benefits of going back to pre-euro national currencies are not always explained clearly, but they usually contain the following points:

  1. Monetary sovereignty would enable depreciation of currencies following an increase in competitiveness;
  2. National central banks would gain back control of monetary policy and they could print money when necessary or convenient;
  3. Converting public debt into a new national depreciated currency would lighten the burden of that public debt;
  4. Monetary sovereignty would allow monetisation of public debts, i.e. the process of “reducing” debts by making national central banks buy government bonds and issue new money.

And what about the costs, if any? Reading the programmes of these movements there seem to be no costs. Entering the eurozone was a big mistake. Can this be true?

The uncertain benefits of exiting EMU

First, there are two main effects associated with depreciation of national currencies. To begin, such an operation would increase foreign demand for domestic goods, since they would be relatively more inexpensive for other nations. Secondly, a decline in the value of a state’s currency would imply a relative increase in the prices of foreign goods. This oft-hidden effect would reduce the advantages of competitive depreciations (Deo 2011). There are three main facts making the alleged benefits of competitive depreciation so uncertain:

  1. For businesses and companies, the costs of imports would increase. The result is likely to create inflation and increase costs for businesses;
  2. Inflation would disproportionately affect the poorest elements of the population. The only way for national central banks to counterbalance it would be to increase the interest rate, thereby causing a slowdown in investment and growth;
  3. It is true that the immediate net effect of this depreciation is likely to be positive. However, to maintain these positive effects in the medium or long run, other depreciations would necessarily follow. It is highly unlikely that this strategy would be tolerated by other countries, marking the end of the single market. In terms of depreciation, European countries cannot compete with low-wage countries like India or China.

We believe that the advocates of competitive depreciation do not account for the fact that the economy has deeply changed in the last thirty years. If depreciation was effective into the 1980s , it is not as effective in a globalised world. International commerce is deeply integrated now, and it is hard to find products made entirely in a single country. As a consequence, there may be almost no effects for a country’s depreciation in the first place.

What about the effects of regained monetary sovereignty on the sustainability of public debt?

  1. Debt monetisation has at least two drawbacks. First, the emission of new money may exert inflationary pressures. Second, and more importantly, it would create problems in holding the governments responsible for their public debts.
  2. The effect of converting public debt in the new national currencies might be positive in theory. Yet, to the extent that this operation is not always possible, the national debt burden would actually increase. In fact, part of it would still be in euros, and it would respond to the depreciation of the national currency as if it were denominated in a foreign one: that is to say it would be relatively more costly. For the same reason, this problem would affect all subjects (companies and banks) with outstanding international debts.

Overall, we conclude there does not seem to be any certain benefit from a potential EMU exit.

Even if it is not possible to estimate the costs of an EMU exit with certainty, it is indisputable (though often neglected by anti-euro movements) that costs have to be taken into account.

To give a sense of the negative effects of departure, we would like to summarise the major analyses on Grexit.

Economists estimate the eurozone, which has already shrunk by a quarter since the crisis started, would contract by another 10% in the first year after Greece’s exit from EMU (Mchugh 2015). Panic would spread between account holders leading to a bank run, as in June 2015.

The new drachma would plunge by 50% or more against the euro as the Greek Central Bank issues money to keep banks going. That would mean imports such as pharmaceuticals, cars and oil would skyrocket in price. In addition, Greek companies owing money to suppliers in euros would suddenly find those bills too big to be paid, forcing some into bankruptcy.

For the eurozone as a whole the costs would be the following: since Greece would most likely find it impossible to repay its bailout loans, the resulting losses would be spread to taxpayers in the other 18 countries. The richer countries would then be even more determined not to share finances with other eurozone members in the future. Finally, the eurozone would suffer from contraction in trade.

Fortunately, despite a month (July 2015) of deep uncertainty on the future of Greece, an agreement on a new bailout for the country was reached, forgoing Grexit for now.

Europe at a turning point: what are the challenges that lie ahead?

Exiting EMU, as we have just argued, does not seem a feasible option at all, yet at this turning point, Europe is calling for change. In order to understand how to proceed, we will set aside the facts and instead focus on two articles from the Treaty on European Union (Maastricht Treaty), art. 123 and 125. What clearly emerges from these is the following: on the one hand, the ECB cannot finance a member state’s public debt by directly purchasing its government bonds; on the other hand, national governments or any institution of the EU should not be liable for another member state’s debt.

These normative constraints, together with the link previously described between banks and sovereign debts, form what has been called New Impossible Trinity (Pisani-Ferry 2012), according to which it is not sustainable for Europe to have the following three characteristics simultaneously (Figure 1):

  1. Absence of coresponsibility between member states for each other’s public debt;
  2. Impossibility of ECB monetarily financing member state debt;
  3. Strong link between sovereign debts and the banking system.
Figure 1: The new impossible trinity (Pisani-Ferry 2 012)

Figure 1: The new impossible trinity (Pisani-Ferry 2012)

Let us explain the way the three elements are connected with one another. Whereas the eurozone is integrated from the monetary side and has a unified capital market, banking systems are still formally national. States, rather than the banking system itself, are the only entities responsible for rescuing banks in the absence of a financial union. As a consequence, states are highly vulnerable to the cost of banking crises, especially when they are home to banks with significant cross-border activities. Thus, if a banking crisis occurs, some states’ sovereign debt would explode, and since there is no fiscal union (i.e. no entity liable for another state’s debt because of the “no bailout clause” previously discussed), the risk of default increases. Could the ECB intervene as a lender of last resort for a failing state? According to the Maastricht Treaty, art.123, the answer is negative. There we are, stuck in an impasse.

First side: the ECB as a lender of last resort

In September 2012 the ECB announced the Outright Monetary Transactions programme (OMT), a tool making the bank closer than ever to a “lender of last resort”. Why is the announcement of this programme such an important achievement? There are three main reasons:

  1. It is a programme through which the ECB can finance almost directly member state public debt, with no ex ante quantitative limits on the size of the transactions, i.e. the bank could give as much help as needed to states in great diffculty;
  2. It has been approved by the Court of Justice, meaning that the ECB has obtained the mandate to activate the programme whenever necessary;
  3. Because of the way it is designed, it alleviates the problem of a country acting irresponsibly knowing that the other member states would intervene to help (i.e. moral hazard).

Thus, even though it has not been used yet, the mere existence of such a programme has turned the ECB into what strongly resembles a potential lender of last resort (i.e. a body that can directly help a country out of a self-reinforcing debt crisis). This allows us to almost solve the issue from one side.

Second side: towards a banking union

How should we deal with the link between the banking system and the European economy? In order to avoid future banking crises, it is inevitably important to improve the stability of the banking system and its supervision. Huge steps have already been made in untying the knot binding sovereign debt to banks. Briefly, the benefits of a banking union can be listed as follows (European Commission 2014):

  1. Banks will be stronger and more immune to shocks: common regulation (Basel III) will ensure effective enforcement of stronger prudential requirements;
  2. Failing banks will be resolved without taxpayer money: the single resolution mechanism (SRM) states that banks will be financed by their shareholders and creditors first, and in only worst cases will bank losses be covered by an ad hoc resolution fund financed by banks;
  3. Banks will no longer be “European in life but national in death”: they will be supervised, and any failure will be managed by a truly European single supervision mechanism (SSM).

What are the political implications of this reform? One possibility is that the EU will be able to mobilise common resources for the protection of bodies operating across borders, thus implicitly authorising partial transfers between states (Altomonte & Sonno 2014).

Third side: is fiscal (and political) union possible?

As mentioned above, each member state has agreed, through the Fiscal Compact, to take the necessary actions and measures to contribute further to the sustainability of public finances and reinforce financial stability. In addition, through the European Semester, the European Commission analyses the fiscal and structural reform policies of every member state, provides recommendations and monitors their implementation. The major achievement of these programmes is that each state has agreed to delegate part of its national sovereignty to the EU institutions by letting them participate in decision-making processes that before the crisis were considered solely national. Yet, some states are finding it difficult to carry out the structural reforms necessary for restoring pre-crisis welfare levels.

Then how do we further foster the process of fiscal integration? One option could be to merge all resources each state can dispose of, increasing the small EU budget and creating a federal one. This would certainly constitute a non-negligible critical mass that would amplify the efficacy of common policies.

The fiscal union is a factor that we believe necessary for the resolution of the crisis, but this will only happen through a common political view and a further transfer of sovereignty.

The main tool to amplify this critical mass is the so-called Eurobond, an issuance of common debt borne by the European institutions whose shared guarantee would be the assets of individual states. Actually, instruments very close to the Eurobond are already being issued, through the emission of e s m bonds backed by common capital (i.e. capital raised from all countries); in addition, according to the recent Five Presidents report (Junker et al. 2015), the EU institutions are considering the creation of an EU treasury.

What is the current political obstacle? Pooling resources, in favour of better spending, implies the presence of a veto of other member states on policies that are traditionally considered national (e.g. healthcare systems or pensions). Still, the fiscal union is a factor that we believe necessary for the resolution of the crisis, but this will only happen through a common political view and a further transfer of sovereignty.

The economic and social model that the European Union has chosen is mainly based on growth and solidarity. Neither of these factors can exist without the other: in fact, if the two elements are not combined together, Europe will not regain the wealth and well-being it knew before the current crisis. Thus, fostering economic growth through the measures described so far is a necessary step which must be addressed through greater solidarity. The answers can only be political, and we must find them in a European context.

Europe must keep in mind its motto “united in diversity”, making it a reality and turning it into an action of economic policy. This means valuing the differences that exist within and between each culture and within common economic visions and policy. It is only through the recognition of differences joined in a single, coherent political plan that individual European countries can hope to thrive in tomorrow’s world.


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It’s the “big finance” that caused the crises!

commentary from New Economics Foundation
Josh Ryan-Collins (Associate Director, Economy and Finance)

We are now approaching seven years since the financial crisis of 2008, yet the eurozone remains mired in economic woe. Unemployment, in particular youth unemployment, remains stubbornly high whilst inflation is dangerously low. Bank lending to firms and business investment remain tepid, despite the European Central Bank’s € 1.1 trillion quantitative easing programme further stifling interest rates (Bryant & Jones 2015).

This essay by students at the University of Bocconi traces the origins of Europe’s current problems and the response by political and institutional actors, arguing that the way forward lies in greater economic and political integration.

The authors are right to point to a number of paradoxes at the heart of the eurozone project holding back recovery. Most obviously, the eurozone experiment had demonstrated the difficulty of having a monetary union whilst attempting to hold on to fiscal sovereignty. Relatedly, a financial system where nation states are responsible
for both regulating and rescuing banks operating internationally is flawed. The paper accurately describes how the growth of excessive leverage by such banks led ultimately to the crisis, which consequently resulted in European states running up large public deficits in order to both bail out these banks and fund a welfare funding expansion in response to rising unemployment.

The authors argue that by having an EU-wide banking union with greater fiscal integration (and ultimately fiscal union), these kinds of problems can be reconciled. They suggest such a solution will be more effective for a given EU country than leaving the eurozone and returning to a national currency. They dismiss political movements pursuing such a goal as “populist” and peddling “unfeasible solutions”.

What the paper fails to do is consider the fundamental causes of the crisis in the first place. It states, “Prior to 2005, a prolonged period of low interest rates made investments in real estate much more attractive than financial products”. But credit creation (bank lending) for domestic and commercial real estate has been increasing as a proportion of total bank lending in most advanced economies since the mid-1980s (Jorda et al. 2014; Turner 2015). Further on, the paper suggests that the reason European banks became involved in purchasing subprime mortgage-backed securities was that the European bank sector is the “biggest in the world”. This is not a causal explanation—simply a correlation.

An alternative explanation for the cause of the crisis is that it was a failure of financial regulation. Deregulation of the financial system led it to engage in speculative, risky and “socially useless” activity that did not support sustainable and productive growth (The Telegraph 2009). This approach is of course difficult to reconcile with mainstream economics which has at its heart the notion of the efficiency of markets. But, as many eminent economists have now admitted, mainstream economics entirely failed to predict the crisis precisely because it was oblivious to the build-up of excessive leverage in the financial system (Stiglitz 2011; Turner 2015).

The solutions proposed by the authors seem based on the assumption that it is inevitable we will have “European banks … well beyond national borders” with assets vastly larger than those of the nation states where they are headquartered. If this is assumed, then it is easy to make the argument that such banks should be subject to Europe-wide or even international forms of regulation. But one can also argue that banks too big—or too complex—to fail are themselves the real problem, not how they are regulated. So, for example, splitting the retail or investment activities of megabanks, splitting very large banks into smaller, real economy-focused regional banks or having public banks, such as the German Sparkassen model, might be a way of reducing financial risk whilst maintaining sovereign control over finance (New Economics Foundation 2013, 2015).

Some of the eurosceptic movements dismissed by the authors are pressing for such a reform of “big finance”. They have argued that devolving further power from sovereign control to technocratic bodies unaccountable to the European people such as the ECB is a step in the wrong direction. The authors would do well to note that attempts at harmonising bank regulation at an international level—via the Basel regulations—have not led to greater financial stability. Rather, banking and currency crises have increased in frequency.

Relatedly, the authors also fail to question the political logic of the austerity programmes the EU has undergone. These programmes essentially punished debtor periphery countries (Portugal, Spain, Ireland, Italy, Greece) whilst supporting the interests of creditor countries in Northern Europe. But there is a strong argument, particularly when using the term “solidarity”, that both creditor and debtor countries bear strong responsibility for ensuring recovery was achieved in a socially just manner. There were and are many alternatives to austerity—creditors could have taken much larger haircuts, the ECB could have taken toxic debts off the balance sheets of vulnerable banks (as the US Federal Reserve did with Fannie Mae and Freddie Mac) and richer countries could have undertaken much larger fiscal expansion or allowed wage appreciation.

With regard to the arguments presented against countries leaving the European Union, there are also some problems. The authors focus on the potentially damaging impact of consumer price inflation that might result from a devaluation. However, one could easily argue that the greatest danger facing Europe at the present time is deflation. When Europe faced a similar situation of very high public and private debts and high unemployment
following WWII, the policy of keeping interest rates low whilst allowing inflation to rise was key to steadily reducing such debts and enabling rapid levels of growth (Reinhart & Sbrancia 2011). The same argument applies to debt monetisation—when demand is suppressed, banks are not lending and debts are very high, monetisation of deficits may be an effective tool (Bernanke 2003; Ryan-Collins 2015).

There are of course arguments for and against all of these alternative proposals. By neglecting to examine them, however, one is left with a rather unbalanced perspective. It may well be the perspective shared by many mainstream economists and financial and political elites of the European Union, but it is one that is being increasingly challenged by those outside this small minority.

New Economics Foundation (NEF) is the UK’s leading think tank promoting social, economic and environmental justice. Its aim is to transform the economy so that it works for people and the planet. NEF is fully independent of any political party, relies on donations and help from our thousands of supporters to effect social change.


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The Telegraph (2009), “City is too big and socially useless, says Lord Turner”, 26 Aug 2009, http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6096546/City-is-too-big-and-socially-useless-says-Lord-Turner.html, accessed 25 Nov 2015.

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