“In Europe, what we have is simply a problem of contracts that cannot be upheld and need renegotiation.”

—Dorsey D. Farr, Ph.D., CFA, French Wolf & Farr, www.frenchwolffar.com

“For the past two years, Americans have been looking down their noses at Europe as if the entire continent was a guest on [The Jerry Springer Show]. After all, Europe is facing some serious challenges, including high unemployment, weak economic growth, poor demographics, infamously high debt levels, and a seemingly unmanageable currency block. A Springer-like sense of superiority and widespread misunderstanding of currency unions have produced a consensus view that casually makes grand doomsday predictions about Europe and the euro. …

Dismissing a €1.8 trillion lending facility as grossly insufficient is a bit puzzling, since the entire stock of public sector debt in Greece, Ireland, Italy, Portugal and Spain is only €2.8 trillion. …

While the problems (and solutions) appear obvious to every talking head and armchair economist, European policy makers are struggling to craft an appropriate response. Providing additional financial aid to Greece simply postpones the inevitable and reinforces undesirable behavior, while cutting them off may send shockwaves throughout the banking system.

Because avoiding a sovereign default seems like priority number one for the political class, capital market participants sit on the edge of their seats each day waiting for signs of a bailout in the next policy announcement. …

The problem facing Europe is not the euro currency, the lack of a fiscal union, or the EU’s inability to achieve consensus between national governments. In Europe, what we have is simply a problem of contracts that cannot be upheld and need renegotiation.

Unwillingness to acknowledge these problems has greatly exacerbated the situation, threatening the European banking system and the global economy. Sovereign debt instruments are the contracts that have received the most attention. Borrowers cannot repay lenders in accordance with the terms upon which they agreed to borrow. Naturally, lenders get a bit feisty when this happens, but a restructuring of sovereign debt (e.g., swapping short-term debt for long-term debt) need not inflict complete chaos in the global economy.…

It is impossible to rectify the sovereign debt crisis without first rewriting the social contract that has produced the excessive debt burdens. Monetary policy did not cause Greece’s troubles, and switching currencies will not solve the problem. Greece, for instance, could potentially orchestrate a stealth default via a return to a devalued drachma.

Such an approach is commonly advocated on TV, but all it would do is make the Greek people poorer by worsening their terms of trade. To be sure, a weaker currency might boost the important Greek tourism industry, but devaluation still seems like a strange prescription for a country that imports three times as much as it exports. More importantly, it does not address the fundamental problem – living beyond one’s means – which cannot be solved unless the social contract is renegotiated and government expenditures are brought in line with revenues.

Greece will default (likely in the form of a restructuring), and the Greek people will suffer the consequences as they are no longer able to access the capital markets to borrow. But there is no reason that Europe (or the EMU) can only be as strong as its weakest member state. Collectively, the European Union is the largest economy in the world. At roughly $16 trillion, it is bigger than the United States. In contrast, Greece is a $300 billion economy – 25% smaller than the state of Georgia with a similarly sized population. It doesn’t need its own currency and shouldn’t hold the rest of the world over a barrel.

Pretending a debt problem is a currency problem may be convenient for those who do not wish to deal with the source of the debt problem. Many politicians have a vested interest in pursuing this type of strategy, since it might allow them to defer tough choices until someone else is in charge. Observe the budget debates currently taking place in America, which has its own debt problem that exceeds that of the European Monetary Union. Painful spending cuts (if any) are always scheduled for the distant future, indicating that no appetite for budgetary discipline exists on either side of the Atlantic. Perhaps we should pause to think before looking down our nose at Europe.

While politicians may be predisposed to patching over gaping fiscal holes and markets seem to welcome schemes that defer painful consequences, the urge to avoid default and use the central bank as a bailout fund for irresponsible politicians and bankers jeopardizes the credibility of the currency and undermines the creditworthiness of the stronger economies that would ultimately pay the bill.