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The fallout from the financial crisis has been particulary challenging in the euro area member States of the South-Western rim and in the new EU member States, due to their previously accumulated macroeconomic and financial imbalances. The perception that the euro enviroment provided a solid shield against economic instability shaped the incentives, expectations and actions of agents, markets and policy makers. this, in turn, eroded discipline at all levels: EU-wide surveillance, domestic policies and markets. The empirical analysis of this paper, focused on market discipline, shows that before the crisis credit risk premia neglected fiscal imabalances and hardly reflected external or finanacial imbalances, in particular in advanced economies. This result is partially explained by the masking effect of the expansionary phase on underlying imabalances. The crisis has shatered the perception of the euro as a safe haven for economic stability, where imabalnces do not matter. Moreover, the severity of the crisis has uncovered the fragilities of the institional framework underpinning the euro and is leading to its reinforcement it by strengthening economic governance and surveillance. Going forward, however. other two factors may have a greater impact for the future discipline and stability of the European economies i) more stringent financing conditions by markets- contingent on fundamentals-, although there are doubts on the persistence of this discipline in the next expansionary phases; and, above all ii)a more sensible behavior of domestic policymakers, consistent with the constraints that EMU implies. These three forces could settle the European integration process and EMU on a more solid footing, though the jury is still out.
