After the financial crisis erupted in 2008, continental Europe on the whole appeared to be in better shape than the US. The main reason was that the big EU banks held smaller amounts of questionable mortgage-backed securities than did American (and British) banks. The housing markets in Germany, France, Italy, and most other member countries-Spain and Ireland are two exceptions- had not boomed as much as the American and British markets.
Unfortunately, the apparent more solid position of EU banks has turned out to be an illusion because these banks held large amounts of euro-denominated sovereign debt of Greece, Portugal, Italy, and other economically weak members of the EU. The presumption of EU banks in holdong so much sovereign debt of weak members was that the strong members would not allow defaults on any sovereign debts issued in Euros. This same presumption led the now bankrupt American fund, MF Global Holdings, to bet billions of dollars on the expectation that sovereign debt of all members of the euro-zone would be paid off in full.
This same expectation explains why initially the weaker “Mediterranean” countries were the most eager to join the euro bloc. They anticipated much lower interest costs on their sovereign debt because they expected the strong EU nations to provide a guarantee of their debt. These countries also expected that the Maastricht Treaty and other fiscal rules would prevent their governments from running up large deficits. At first, these expectations were met, as interest rates on the sovereign debt of weaker countries fell to levels not much above that of Germany’s, the strongest member of the EU. The significant fiscal deficits of the weaker EU members did not seem important in a world with booming EU and world economies.
All these expectations crashed with the onset of the Great Recession, and the resulting decline in government revenues, and the retreat by banks and other investors from risky assets. As a result, interest rate spreads between sovereign debt of Germany and France and countries like Greece, Portugal, and Italy have soared, and some direct or indirect default on the sovereign debt of these weak countries seems highly likely- which is why they are being forced to pay higher interest rates on new debt.
What can be done now to prevent a catastrophe in the EU that would plunge Europe into another recession, and hurt badly the world economy as well? I opposed the formation of a common European currency because it did not allow weaker members enough levers to adjust to various idiosyncratic shocks they would inevitably face. This view has turned out to be correct, but a return to separate currencies in the middle of the crisis is likely to be highly disruptive.
At the opposite extreme of a break-up of the euro are proposals for some or all of the sovereign debts of individual member countries to be replaced by euro bonds guaranteed by the EU community as a whole (read mainly Germany and France). One recent idea advanced by Germany’s Council of Economic Experts is to have joint liability for all euro-zone debt above 60% of a country’s GDP, while each country would still have to manage payments on the rest of its debt. Even with high interest rates of 7% or more, weaker countries might be able to manage interest payments on debt equal to 60% of its GDP. Presumably, moreover, these interest rates will fall when the EU is guaranteeing a good portion of the total debt. The EU share of the debt would be paid off over a 25-year time period through tax revenues set aside for this purpose.
In the short run this is likely to reduce significantly the crisis. This is especially so if taxpayers in Germany and elsewhere do not rebel either at the additional taxes they will have to pay to fund the sovereign debts of weak members, or if banks get off lightly despite their risky investments in sovereign debt. In the longer run, this plan for euro bonds backed by joint liability of EU countries would require joint control over issue of debt above the 60% mark since that debt would be the obligation of all euro-zone countries. This would necessarily lead to some type of at least temporary fiscal union regarding sovereign debt issue.
Many have recognized that fiscal union is a necessary part of any long-term solution to maintaining the euro. The euro bond approach set out in the previous paragraph is an indirect way to achieve at least partial fiscal union. It will be helpful in the short run, but I doubt if fiscal union alone will preserve the euro in the long run. Weaker member nations will continue to be stressed by shocks to their economy and to their fiscal balance sheets, with many of these shocks not easy to anticipate in advance. The crisis helps demonstrate that a common currency makes adjustment to individual country shocks far more difficult than when countries can devalue their own currencies. This will continue to be a devastating weakness of the euro unless labor and product markets became much more flexible in the euro-zone, and unless labor mobility across member nations increases greatly.