Thursday, February 4, 2010

The Sovereign Debt Crisis: A Constitutional Moment for Europe?

After today's 268 point drop in the Dow Jones Industrial Average, it's clear that the sovereign debt crisis has investors rattled. What started late last year as a smallish, but high profile anticipatory default by Dubai last fall, quickly smoothed over with a partial bailout from Abu Dhabi, has morphed into a European problem. Greece seems to be in the worst shape among Euro bloc nations, with credit default swaps for its debt imitating a jack-in-a-box. Portugal, Ireland and Spain increasingly receive unflattering coverage in the financial press. The wealthier Euro bloc nations--Germany, France and the Netherlands--noticeably squirm when the news coverage turns to the question of bailouts. The European Union puts on the appearance of threatening to get a buzzcut and administer tough love. But it's hard to imagine that the EU would actually give Greece the boot. That would almost surely result in Greece defaulting on its sovereign debt, which would escalate the pressure on other weak European nations and turn the crisis into a panic. It would be like letting Lehman Brothers fail, only on an international level. We remember how the Lehman thing turned out.

So a European bailout, however distasteful to French, German and Dutch palates, is likely. The question is what conditions the bailors will impose. The problem is that the European Union prescribes fiscal conditions for membership (i.e., member nations are supposed to limit their governmental budget deficits to 3% of gross domestic product), but doesn't have much control over member nation finances. While the EU can kick out offending members, that's a nuclear remedy that can't feasibly be used in the real world because it would only make things worse. But handing over bailout Euros would reward the profligate nations at the expense of the prudent ones. (Does this sound familiar to American taxpayers?) The German, French and Dutch may refuse to simply write checks.

Europe is facing a dilemma not unlike the newly independent United States in the 1780s. The Revolution had been very expensive, and both the individual states and the Continental Congress incurred substantial debt to pay for the war. At the same time, their ties to each other were far weaker than today, while their differences led to no end of commercial disputes and debates about who should pay the Revolutionary War debt. The infant democracy was in danger of falling apart, and convened a constitutional convention to try to redraft the nation's legal framework. The result, so deeply flawed that it led to a bloody civil war 72 years later, was nevertheless workable enough that today we still limp along with it, in somewhat amended form, in spite of the legislative dysfunction it allows where Senators need to work only when 60 of them are so inclined. But one benefit of the Constitution adopted in 1789 was that the newly reconstituted United States government assumed responsibility for all Revolutionary War debt, whether incurred by the states or the earlier government under the Articles of Confederation. Thus, the price of a national bailout of the states was a far stronger federal government.

Just as the original thirteen American states couldn't afford to splinter apart, with covetous, imperialistic European nations waiting to snatch them up, the European Union cannot afford to splinter apart. This is not so much about the economic benefits of unification--lowering trade barriers and other costs of doing business and thereby spurring production and growth--as it is about the renewed financial crisis a failure of the European Union would create. But to hold the EU together and legitimize the bailout(s) for the electorates in the wealthier member nations, greater authority would probably have to be given to the central government in Brussels, especially over fiscal matters. Getting there would be difficult, just as the drafting and ratification of the U.S. Constitution was difficult. But survival may well depend its success, and necessity is the mother of invention.

If the EU achieves greater fiscal unity as a result of the sovereign debt crisis, its populace can take comfort from the world's recent rediscovery that prudence is a better long term strategy than profligacy. And other big spenders--such as Japan, the U.K., and, of course, the United States--should take notice that lunches aren't free, not even for sovereign nations, even if it takes a while to get the bill.

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