The Euro Crisis and Euro Bonds

by Gary S. Becker

The Becker-Posner Blog
November 27, 2011

After the financial crisis erupted in 2008, continental Europe on the whole appeared to be in better shape than the US. The main reason was that the big EU banks held smaller amounts of questionable mortgage-backed securities than did American (and British) banks. The housing markets in Germany, France, Italy, and most other member countries-Spain and Ireland are two exceptions- had not boomed as much as the American and British markets.

Unfortunately, the apparent more solid position of EU banks has turned out to be an illusion because these banks held large amounts of euro-denominated sovereign debt of Greece, Portugal, Italy, and other economically weak members of the EU. The presumption of EU banks in holdong so much sovereign debt of weak members was that the strong members would not allow defaults on any sovereign debts issued in Euros. This same presumption led the now bankrupt American fund, MF Global Holdings, to bet billions of dollars on the expectation that sovereign debt of all members of the euro-zone would be paid off in full.

This same expectation explains why initially the weaker “Mediterranean” countries were the most eager to join the euro bloc. They anticipated much lower interest costs on their sovereign debt because they expected the strong EU nations to provide a guarantee of their debt. These countries also expected that the Maastricht Treaty and other fiscal rules would prevent their governments from running up large deficits. At first, these expectations were met, as interest rates on the sovereign debt of weaker countries fell to levels not much above that of Germany’s, the strongest member of the EU. The significant fiscal deficits of the weaker EU members did not seem important in a world with booming EU and world economies.

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