How Europe’s New Unstable Equilibrium Will Help Solve Its Sovereign Debt Crisis

The euro area sovereign debt crisis is gradually turning into the best thing that has happened to European Union politics and European economies since the launch of the Single Market in the mid-1980s. The crisis has shattered the fake ten-year political and economic equilibrium between core and periphery countries that followed the initial shock of euro introduction. That sham equilibrium was based on the feel-good factor of illusory growth from real estate booms and credit financed consumption sprees. It was enabled both by incompetent financial market credit risk assessments that allowed Greece to borrow at German interest rates for a decade and also allowed European governments to believe the comforting, but erroneous signals from financial markets. After all, if Greece could borrow at German rates, who in Brussels could question it? It must have meant that the dream of European integration and economic convergence was really happening, that "Brussels" was competently steering Europe toward "ever closer union" and that all Europeans would enjoy Luxembourg’s standard of living1.

Instead the tide that was supposed to lift all European boats has gone out. Euro membership has become a kind of prison shelter, protecting country inmates from the mean streets of global financial crises, but allowing unpleasant things to happen to the weak, unless they reform before entering or prepare to do politically heavy lifting on reform once inside2.

The European political and institutional response to the latest crisis, had to navigate 27 national domestic political constituencies. Inevitably it limped behind. Yet the fact that it took only about 12 months from May of 2010 to negotiate the new permanent euro area crisis facility to be known as the European Stabilization Mechanism (ESM) is testimony to the innovative capacity of the European Union. The ESM is a permanent new EU institution built to last, and it was wise for leaders not to rush into it.   The result has been a new political and economic equilibrium between the core and periphery of Europe. However unstable it is in the short run, this new equilibrium could ultimately help resolve the European sovereign debt and banking crisis.

Most financial market analysts and non-Europeans who have overlooked these accomplishments have committed two important fallacies.

The first fallacy: The European Union is not a "club" or mere free trade area that any member can easily decide to leave. There has been a tendency to forget that euro area members have given up much of their sovereignty to join.  

More than half of the economically meaningful legislation passed by EU members’ national parliaments every year consists of implementing EU-based rules negotiated in Brussels. EU government cabinet members or their deputies go to Brussels each week to negotiate such legislation with their European counterparts. Indeed, they are probably in session in Brussels more days than the US Congress!  The costs of leaving the euro area for both strong and weak countries are catastrophic3. Euro area membership entails significant de facto restrictions on any member state’s sovereignty, forcing each member to engage in an infinitely iterated game with its fellow members4. Accordingly, the strategies available to EU member state governments differ from those utilized by creditor and debtor governments in other sovereign debt crises. Historic or emerging market experiences are not relevant to possible internal EU and euro area crisis solutions.

Think of the issue of foreign vs. domestic debt. Inside the euro area, where sovereignty is pooled and the central bank shared, this becomes a complex multi-layered issue where Greek debt held by other euro area countries are not truly "foreign debt" in the same way that Argentinean government debt held by American banks is. The Greek government cannot simply stiff its "not quite foreign" creditors in the euro area, because France and Germany can retaliate. Unilateral declarations of sovereign default like Argentina’s in 2001 are not a winning or rational strategy. Euro area players will choose to cooperate with one another far more than sovereign nations usually do with their foreign creditors5. Just as the distinction between public and private sector debt is in a country facing a crisis becomes blurred, so too does the distinction inside the euro area between "peripheral debt" and "euro area debt."

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