Castles in the Sky: The Fundamental Problem with Efforts to Save the Euro

The €700 billion bailout fund created by European leaders for the euro zone last week may be sufficient to protect Greece, Ireland and Portugal from having to admit complete failure. But if Spain and Italy run into trouble, the fund will have to be expanded to such an extent that it will become too heavy a burden for those contributing to it. Germany and France, as the most important financiers of the euro zone, might even find themselves having to beg for money.

Besides, it's a known fact in economic life that both a bankruptcy and the postponement of a bankruptcy can generate costs. When applied to the euro crisis, this means that there is a point at which delaying the bankruptcy of the European community of nations becomes more costly than an orderly insolvency of its most delinquent borrowers. There are reasons to suggest that this point could soon be reached:

• Debt servicing is threatening to overwhelm some crisis-ridden countries. Greece is cutting wages, pensions and government spending to an unprecedented extent, and yet the country's debt will continue to grow to 165 percent of GDP by 2015. Portugal is imposing one austerity measure after the next, and yet this is only stifling the economy even more. Prime Minister José Socrates resigned in frustration last week. But the longer the governments in Athens and Lisbon delay a presumably unavoidable debt restructuring, the more they will have to pay in interest and the greater the burden for the euro bailout fund.
• The European banks are in better shape than they were a few months ago. When the debt crisis erupted, governments funnelled large amounts of liquidity and equity capital into the banks. At the same time, lenders benefited from favorable conditions in capital markets. They could borrow money from the central banks at extremely low rates and then lend the money to crisis-ridden countries like Ireland or Greece at much higher rates. As a result, the banks benefited from the crisis in two ways. On the one hand, they profited from the high returns being offered for the bonds of threatened countries. On the other hand, they assumed almost no risk, because Europe's bailout funds guarantee debt service.
• A so-called debt haircut would impose burdens on lenders and borrowers in the short term. The banks would have to show losses on their balance sheets, while the governments would be denied access to new loans for a fairly long time. In the long term, however, a debt restructuring would have a beneficial effect on capital markets. Countries with a high default risk would be forced to tighten their belts because of their rising interest costs. And lenders would invest less money in high-risk countries, because they would be forced to incorporate losses into their calculations. It would be a strategy that combines overcoming the old debt crisis with preventing a new debt crisis.

Of course, more is needed to make such a crisis concept a success than merely the goodwill of governments. Europe has to set priorities. Measures to overcome the debt crisis are the most urgent. If a country can no longer service its loans, banks and other financial institutions must also make sacrifices, and must do so regularly and not on a case-by-case basis, as called for under the summit resolutions.

The politics of symbolism to support the European cause is unnecessary. The community doesn't need an overinflated economic government or an empty competition pact, nor does it need Europe-wide rules dictating retirement ages or a Brussels commission to harmonize gross income levels.

What is urgently needed, however, is an institution to monitor Europe's debtor nations, provide assistance in times of need, implement austerity programs and, if necessary, restructure debt. What is needed is a European monetary fund, paid for by the members of the euro zone and as free from the influence of governments as possible.

Such an institution would benefit Europe more than an instrument to manage credit crises. The fund would be a symbol. It would show that private lenders are involved in the consequences of a crash and that politicians cannot shift their responsibility to Brussels. In the future, it would become clear once again that there is a relationship between risk and return, and that decisions on budgets, taxes and debt are made by the institutions with the democratic authority to do so: the national governments.

This would also be in keeping with the writings of Robert Mundell, whose 50-year-old essay might still be used to support the theory that the common currency requires a political union. Ironically, Mundell never supported such a position. On the contrary, in his essay he writes specifically that a monetary union can also function within a confederation of states if labor and capital, as well as wages and prices, are only adequately flexible. For this reason, the question of whether the euro can survive cannot be decided in an abstract way. It is, as Mundell wrote in typically academic language, "an empirical question."

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• Part 1: The Fundamental Problem with Efforts to Save the Euro
• Part 2: Pursuing the same old Illusionary Policies
• Part 3: Postponing a Bankruptcy can Generate Costs