A Smart Guide to Thinking About the European Debt Crisis

The rolling tide of European debt stories can be confusing if you pick up the paper and face the deluge of numbers: bond spreads, risk premiums, debt-to-GDP ratios. But at the end of the day, it's really just story about money -- people lending money, governments spending money, and banks and nations running out of money to lend and spend.

One way to think about the European crisis is imagining what would happen if, say, Alabama were allowed to control its own taxes and spending and got into trouble. What if Texas refused to lend a hand, and the United States didn't have the authority to bail it out? Alabama would risk breaking promises to holders of its debt or raising taxes dramatically on its citizens. That's a very simple way to explain the choices facing countries like Greece and Ireland today.

When the euro was launched a decade ago, critics of the single currency said that it would prove impossible to run a single currency without also establishing a fiscal union. The reason generally given was that the countries inside EMU would face a free rider problem, under which those governments with a history of fiscal profligacy would choose to run much higher fiscal deficits, secure in the knowledge that they would not face either a run on the currency, or a rise in domestic interest rates. In practice, this situation did indeed arise in the case of Greece but, contrary to fears, it did not arise elsewhere. Ireland, Portugal and Spain all found themselves in severe financial difficulties, but in none of these cases was fiscal profligacy the root cause of the problem. So fears of fiscal free riding were, for the most part, misplaced.

However, the critics of EMU also aimed another argument against the design of the monetary union. They said that in the absence of a central fiscal authority (i.e. a European central budget), there would be no mechanism to redistribute the costs of a severe economic shock from the weakest members to the strongest. They pointed out that the federal government in the US has a budget which is many times bigger than the central budget of the European Union, a fact which would greatly increase the efficacy of the burden sharing mechanism within the US dollar zone. In the US, the financially strong states of the union would automatically support the weak states when the economy hits trouble. This would not be the case in Europe. And the problem would be even greater if there were an asymmetric shock which hit one group of countries harder than others.

Read the full story at FT.