The European debt crisis -- which saw its latest iteration inaugurated on Wednesday, April 6, when Portugal indicated it would request an EU bailout -- has exposed every single lie, every fudge, and every political, legal, and economic loophole that went into making the continent's common currency. One reason Europeans have yet to set the euro right is that they still haven't reckoned with the extent of bad faith that went into its creation.
To sell the euro to a diverse populace back in the 1990s, its advocates made a series of mostly inconstant promises. The Germans were promised that monetary union would not give rise to fiscal transfers, and would create a currency at least as stable as the Deutschmark. The French understood the euro as a vehicle for improved domestic competitiveness and global reach. For the Italians and the Spanish, it offered an opportunity for monetary stability and permanently low interest rates. And in countries with highly deregulated banking systems, such as Spain and Ireland, it brought the prospect of sudden wealth.
The various promises culminated in a lowest-common-denominator governance regime. Monetary discipline would be enforced by an independent central bank tasked with ensuring price stability. Fiscal discipline was supposed to be covered by the stability and growth pact, which set the famous 3 percent rule -- the ceiling of permitted annual deficits in relation to gross domestic product. And that was it.
Given this wishful thinking, the eurozone was always vulnerable to a financial crisis. But in a fit of denial, Europe never developed a crisis-resolution mechanism. Instead, it promoted a set of logically inconsistent principles: no exit (no leaving the eurozone and reintroducing national currencies), no default (all sovereign debt contracts should be honored), and no bailout (no fiscal transfers between member states). While the no-bailout pledge was explicitly enshrined in European law, and the no-default principle was tacitly agreed upon by European leaders, the no-exit principle was rarely, if ever, explicitly mentioned. The various EU treaties simply allow no procedure for it. The only formal exit procedure is the nuclear option -- a complete withdrawal from the European Union. While the absence of real governance meant some sort of crisis was likely, the lack of any sensible management plan meant such crises were always liable to spin out of control.
The current crisis was sparked when the continent's macroeconomic imbalances collided with a badly regulated and badly capitalized banking system. Germans tended to have excess savings -- their country ran an 8 percent account surplus in 2008 -- and European banks enabled them to easily and massively invest in Spain and Ireland. With the influx of cash, housing bubbles subsequently grew in both countries, with housing prices rising more than threefold in the span of a few years.
This was originally mostly a private, not a public, sector problem: If Europe has a sovereign debt crisis today, that's not what it was at its origin. Indeed, Spain and Ireland ran fiscal surpluses for most of the last decade, and both countries were considered fiscally righteous at the time. Portugal ran deficits, but its debt-to-GDP ratio was only a little higher than that of France and Germany. Greece was the only country in the eurozone's periphery that experienced a classic fiscal crisis: In the year 2009, the country ran a deficit of 15 percent of GDP.
It was the political decisions made by European leaders that ultimately put the solvency of individual countries at risk. The single gravest error in the EU crisis-resolution process was the decision by eurozone leaders back in October 2008, following the collapse of Lehman Brothers, to pursue a chacun-pour-soi (every-man-for-himself) approach to banking resolution: Each country would guarantee its own banks. With that decision, the banking crises in the eurozone's periphery became a series of contagious, national fiscal crises. If eurozone leaders had set up a eurozone-wide rescue fund for ailing banks, accompanied by a bank resolution regime, the crisis would have remained contained in the private sector. If the EU had sorted out the banks back then, it could have chosen among a variety of options in dealing with the one genuine fiscal crisis it had in Greece.
Eurozone leaders then doubled the error by focusing on the symptoms rather than the cause of their troubles.
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