Eric Posner and Mitu Gulati Explain How Not to Solve the European Debt Crisis

How Not To Solve the European Debt Crisis
Eric Posner and Mitu Gulati
December 2, 2010

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