How Does Europe Solve its Debt Crisis?

by Odysseas Papadimitriou on November 29, 2011

Whether you are well-versed in international economics or not, you’re probably aware that Europe is having substantial problems. You’re also likely familiar with the resulting worldwide ripple effects: uncertainty amongst investors, fears of a global double-dip recession, and widespread political upheaval, just to name a few. Of course, there are a number of prominent theories for how to solve Europe’s debt crisis, but given the depth and complexity of the problem, none is perfect and each requires tough choices to be made. People – not just in Europe, but around the world – need hope, however. We need a plan, a sense that these economic issues are finite and not permanently debilitating. So, with that being said, what say we take a quick look at four different courses of action that Eurozone governments can take, the pros and cons of each, and which will provide the most long-term benefit without causing short-term chaos.

Option 1: Economically sound European countries pay down southern debt
This plan would involve countries like Germany, the Netherlands, and Finland using savings, tax revenue, and export surpluses to help pay down the debts of southern neighbors like Greece, Portugal and Italy until they are at manageable levels. Such an approach is logical in the sense that the economies of European Union (EU) nations are interconnected, and the default of one or more countries would have negative repercussions for others.

However, as you can imagine, it would be very tough for the German, Dutch, and Fin governments to sell this plan to their people, as it is essentially tantamount to rewarding neighbor nations for their mistakes without receiving much tangible benefit in return. Ultimately, while this plan would undoubtedly be effective if implemented, the political hurdles are just too high for it to be realistic. Just think: If you live in Virginia and both you and your state government have been operating within your means for years, would you want to bust open the piggybank to bail out California, for example? Probably not.

Option 2: Problem countries cut deficits
At first glance, this is likely the most logical course of action, but cutting deficits would require significant spending cuts, which would, of course, mean higher unemployment rates, lower tax revenue, and increased social service expenses (e.g. unemployment benefits, health care, etc.). This would foster a vicious cycle in which more and more cuts would be required to offset revenue lost as a result of a shrinking economy, which would lead to social unrest, bringing citizens to a breaking point and causing them to want to leave the Euro. This brings us to Option 3.

Option 3: Certain nations leave the Euro
If problem nations were to leave the Euro, they could just default on their debts. As a result, their currency would be significantly devalued, causing tourism and all export goods to become dirt cheap while making imports prohibitively expensive. However, there are a few problems with such a plan. First of all, speculation over the next country to leave the Euro would run rampant, forcing otherwise stable nations to leave unnecessarily. In addition, banks both in the countries that leave the Euro and those holding large amounts of sovereign debt would become insolvent, triggering a financial crisis multiple times bigger than that caused by the Lehman Brothers collapse. This would wreak havoc on markets around the world. Finally, even under the assumption that an exodus from the Euro could take place in an orderly fashion, the Euro would appreciate significantly without the weaker countries, thereby killing German exports.

Option 4: European Central Bank prints more currency
The European Central Bank (ECB) could also print more Euros in order to pay down all of the continent’s debts and bring them to manageable levels. This approach could work if: 1) future issuance of debt could only be done at the EU level and not at the country level and 2) tax collection became centralized at the EU level as well.

Such measures are necessary because a mechanism is required to prevent countries from simply choosing not to make payments toward their fair share of the European debt. By federalizing the issuance of debt and tying each country’s ability to leverage it to their tax revenue, you ensure that no country puts an unfair debt burden on its neighbors. By federalizing tax collection and only distributing funds to individual countries after their debt payments have been removed from the pot, you don’t run the risk of countries overspending and not making debt payments.

Ultimately, Option 4 is the best course of action because it would ensure a united Europe, make use of the continent’s already interconnected economies, and, perhaps most importantly, provide both immediate results and a logical plan for how to move forward that would engender hope within the citizenry. It would also end the speculation over which nation is next to default and thereby lower market volatility. Sure, it would require that individual nations forgo some autonomy, but all things considered, this is the option with the most upside not only for all of the countries in the Euro, but also for the health of the worldwide economy. It’s time for Europe to realize that the solution to its problems involves coming closer together, rather than moving further apart.

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