Blame the Euro

How did Europe burry itself in debt? It all has to do with the Euro protecting profligate southern nations from the discipline bond markets usually would have imposed.

Normally the interest rate a nation has to pay on its debt is based on two thing, expected inflation and the risk of default. In cases where a country is in control of its own currency the risk of default is pretty much zero, since they can always inflate away their debts. As debts increase so does the temptation for governments to generate higher inflation lowering that debt in real terms, to compensate for that potentiality markets will demand a higher interest rate. But for a euro country the power to print money and thereby generate inflation was taken from the individual member nations. Since inflation expectations now were the same for all euro member no matter how much they borrowed all euro members could borrow at the same low interest rate. Allowing profligate members to borrow in a manner that had previously been impossible.

Then the financial crisis hit, governments had to take on the debts of failing banks and try to compensate for drop in private sector demand all while tax revenues dried up. For those who had already borrowed excessive this added debt became too much. It rose to such levels where markets started to fear that they would simply refuse to pay back the money they owed. So they started to demand a higher interest rate to compensate for the risk of these countries actually defaulting on their loans. Interest rates they could afford to pay, making a default even more likely, leading to even higher interest rates and so on.

This whole crisis would never have arisen if it wasn't for the euro. The bond markets would not have allowed any indebted nation to borrow like in such a reckless fashion.

In order for Europe to not find itself in this situation again a variety of measures are started to be implemented. Mainly legal limits on how a member country can borrow, both in the form of treaties and national legislation. Such limits of course existed before the crisis but were simply ignored. Hopefully these will be design in such a way that they can't be. Potentially by handling the power to punish rule breakers over to the European court of justice.