Most commentators have missed the crux of the European debt crisis. The root of the crisis has nothing to do with sluggish growth rates, profligate Mediterranean governments, and unsustainable welfare states. Talk about austerity, lack of a natural currency region, or need for greater fiscal union miss the point.
The basic problem is that Europe cloned a banking system that was designed for nation-states ( such as the U.S., Japan, or pre-Euro Germany) without understanding how it applied to a federation of independent states.
There is not enough money in the world to pay back America’s national debt. Total United States currency (paper and electronic entries in reserve accounts) sums to about $2 trillion. The national debt sums to over $14 trillion. If people ever really suspected that the U.S. monetary printing press was broken, there would be the mother of all bank runs. Bond holders would redeem their U.S. debt instead of rolling it over. Savers would hold tightly to any real currency. The entire banking system would collapse. But such a crisis has no chance of happening because the Federal Reserve promises to buy up government debt with cash as demand for currency rises. American government debt is thus risk less. Since it is both risk less and it pays interest, nobody actually redeems their treasury bills for real currency, and the ratio of $14 in ‘debt’ to $2 trillion in currency can be maintained forever.
The reality of American treasury “debt” is that it is not really debt. Treasury bills should be considered part of the money supply – TBills are simply dollars with not valid dates. T-Bills are equivalent to restricted shares in a company.
The European financial system operates in the same manner. The monetary base – actual currency and reserves – is about $1.3 trillion. The total amount of government debt runs in the tens of trillions.
Thus the key thing to understand about Europe is that no country in Europe is solvent. No country can pay back its debts without the central bank printing money. The only reason Greece ran into trouble first is due to the perception of insolvency. Since Germany is perceived as responsible, people still buy Germans bond. The entire Euro-Zone is having a Wile E. Coyote moment. The Greece bondholders looked down first and are falling. But if Euro bond holders refuse to buy bonds, and wish to redeem their holdings, no government in Europe could stay solvent. How is it possible for Germany to pay back $4 trillion in debt when only $1.3 trillion real Euros exist?
But Europe has a problem, because if the European Central Bank acts like the American federal reserve, and buys up government debt as needed, it is essentially transferring money to that government. All the countries in the Euro-zone would race to issue more debt and have the central bank give that country cash.
So how to fix Europe?
The best solution has two parts a) all sovereign Euro debt is assumed by the European Central bank. The bank prints money to retire the debt as it matures. b) Each country is given a one time grant of Euros equal to 150% GDP. (or perhaps base the grant on population or a combination of GDP and population – this boils down to a political question of who gets what). The grant amount is reduced by the amount of debt assumed by the central bank. So Greece nets a grant of 10% of GDP while Germany nets a grant of 70% of GDP. (1)
This solution makes the entire Euro-zone solvent. The debt crisis disappears. But the solution does not punish responsible countries. Everyone receives the same grant, those with less debt now have cash in the bank they can spend. Germany can use its trillions to issue a general dividend to all citizens, send a man to the moon, or do whatever else it fancies.
After the above solution, going forward there is only one golden rule of the Euro-zone – sovereign countries cannot issue debt denominated in Euros (2). If Greece wants run deficits in the future, it must borrow in dollars, gold, yuan, bitcoin or its own scrip. But it cannot run deficits in Euros (3). If there is a recession, any counter-cyclical/stimulus spending should be handled by the central bank. The central bank should print money and grant wads of cash to each country on a per capita or per GDP basis.
(1) Some might view this policy as a wee bit inflationary. But the actual amount of inflation will not be that great. Price inflation requires people to have more purchasing power to bid up goods. After this plan, Greece will not have much money in the bank to spend, it will simply be free from having to undergo massive austerity. Thus the plan will be anti-deflationary, not inflationary. Germany will have a huge chunk of cash to spend. But I’m guessing the responsible countries will only spend this cash gradually, if at all, and thus the inflationary impact will be limited. Also some inflation is appropriate to get the economy back on track. And inflationary is only really bad when it transfers money from the savers to the profligate. But this inflation will be the result of giving savers the same purchasing power that the profligate already abused.
(2) An a possible alternative solution is that the European government allows issuing of Euro denominated debt, but swears to the ghost of Ludwig von Mises that it will never bail out a member state. If the market believes this promise, the valuation of government debt will drop continuously as a government issues new debt, rather than all at once during a crisis. Thus there will be no big crisis moment that causes contagion. But I do not think the Euro central bank could make a promise strong enough for the markets to believe, so I think you end up back in the same situation in a few years.
(3) Frankly, there is almost never a need for a country to go into debt. Debt is useful for entities that have a life cycle. People go into debt when young to buy a home, and then pay it back as they age. Companies go into debt to buy capital, and then pay it back as they mature. But a country (should) never die. There is no reason to pay for tomorrow what can be paid for today. The only reason ever to go into debt is if you have a tremendous, one time expense, that is large in relation to current income. Buying a home or a factory qualifies. But countries almost never have single one time expenses that are large in proportion to GDP. Thus they should never go into debt. Even a highway should be an operating expense for a country. The only time a country should go into debt is during war. But that’s hardly an issue for Europe right now. Better that the financial system be structured to make it more difficult to wage war.