Once, the smart money was betting on a new economic geography where nations were united in regional alliances to share markets and monies. Now the Euro-Union's scramble to contain a selfinflicted debt crisis provides a cautionary tale of what happens to monetary union when promises are broken, markets are misled, and geopolitical dreams override economic good sense.
Sharing of tax rolls between profligate and prudent nations was never the intent of euro founders. But it became the de facto result when Greece became the first insolvent member of the monetary union. EU Commissioner Joaquín Almunia's pronouncement that "In the euro area, default does not exist," was backed up by an EU/IMF €750 billion fund that promised bailouts to any and all.
Bavarian business owners became unwilling co-signors on the unchecked spending and borrowing of their Athenian neighbors; the Greek people were denied a fresh start and stared ahead to a 25 percent drop in living standards and a decade of stagnation; and the euro was debased as an "independent" European Central Bank was stuffed with €76.5 billion of risky Greek, Portuguese, Spanish, and Irish government bonds. Market prices signaled that the Euro-Union had failed its first stress test.
Much has been made of Europe's current move toward fiscal union. But from its inception, a monetary union that forbade the transfer of debt from one national treasury to another had stumbled across the line. Members were bound to limit deficits to 3 percent of GDP and national borrowing to 60 percent of GDP. A watchdog European Commission would enforce compliance. This ad hoc performance guarantee homogenized credit risk just as the common currency homogenized foreign exchange risk. Now, all member debts were transformed into "virtual" Euro-Union bonds without the fine print.
Markets applauded and soon all of Europe borrowed at low German rates. Greece's five-year cost of funds fell from 8 percent above Germany in 1998 to a 0.5 percent spread in January 2001 when it joined the euro and down again to 0.2 percent from 2002 until 2008 (Figure 1). The fiscal illusion reduced the Spanish Treasury's borrowing bill by €8-€10 billion every year.
While governments gorged on cheap debt, the overseers in the counting rooms in Brussels looked the other way. Rules without punishment for transgressors soon proved worthless. Even after a windfall of three years of revenue growth, seven of the euro's twelve members (with 77 percent of the union's GDP) were over the 60 percent debt limit in 2006. Three of these (with 24 percent of combined GDP) averaged a debt-to-GDP ratio of 97 percent. By 2010, the debts of ten of the original members (97 percent of the combined economy) had climbed over the Maastricht limit; six of these (49 percent of the union's GDP) owed 83 percent to 124 percent of national income (Figure 2). Over-borrowing was not the exception, but the new rule.
Markets that had carelessly bought euro promises in times of plenty woke up in October 2009. Greece had confessed to a true 2008 fiscal deficit of 7.7 percent of GDP and a projected 2009 shortfall of 12.5 percent, both double the fictive numbers published just months before. Investors were on the hook for €300 billion of Greek bonds, twice what the country warranted on its own credit. They had been drawn to lend at low-risk rates to high-risk borrowers. Bond prices crashed, not just for Greece but for all stressed governments. Market calculators rejected the arithmetic of the stop-gap emergency funds rushed out by Germany and France. The €110 billion to shore up Greece would last only eighteen months. The €750 billion bailout fund turned out to be worth only €550 billion and fell far short of its promise to guarantee the credit of every euro member.
The will of spendthrift governments to reform and the long-term tolerance of industrious taxpayers to underwrite shiftless partners were deeply discounted. But most of all, investors assigned little value to the word of a union all too willing to excuse the shortcomings of colleagues across the conference table.
Adam Lerrick is a visiting scholar at AEI.