Eric Posner and Mitu Gulati Explain How Not to Solve the European Debt Crisis
The debt crisis in Europe presents a big political problem: Wealthy countries, chiefly Germany, must either agree to subsidize poor countries or abandon the euro so that Greece, Ireland, and other countries on the verge of default can reduce their debt payments by devaluing their currencies. The first option is politically explosive; the second is politically catastrophic. To duck this unwelcome choice, heads of government like German Chancellor Angela Merkel and French President Nicolas Sarkozy have proposed a variety of legal mechanisms that sound new and enticing. But these proposals are a smoke screen. The reality is that the necessary legal tools already exist, and they're not being used because they would actually make the crisis worse.
When creditors first lost confidence that Greece could repay its debts, the problem appeared to be internal. The Greek government had cooked the books, and once creditors discovered this, they refused to make new loans. Europe stepped in with loan subsidies, but only after a moment of hesitation that planted a seed of doubt for the creditors of other European countries. They realized that if Europe was unsure whether to bail out Greece, it might not bail out other countries in financial distress.
Next came Ireland, with less public debt than Greece, but a banking sector that had massively overlent during a bubble. Because a government can't let its banking system fail, creditors realized that Ireland would have to take on this massive debt, and the Greece crisis repeated itself. At this point, Merkel suggested that in future sovereign debt crises, the creditors should not be paid in full. This proved another serious mistake that pushed Irish banks—and hence the solvency of the Irish government—to the brink.