Is the euro zone’s flaw fatal?

It’s natural to assume that Europe’s debt crisis is roughly analogous to America’s financial crisis: a crisis in which institutions that were too big to fail were burdened by too much debt to survive. In Europe’s case, the institutions are Southern European governments and the banks that hold their debt.

The good news is that we know how to cure that disease. It’s not a cure anyone likes, exactly. It requires the central bank to buy enough of the toxic assets to stop the runs and taxpayers to bail out or take over the insolvent institutions. But it works. In recent weeks, American policymakers have even been giving Europeans technical assistance on exactly how we carried this out in 2008.

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But though Europe’s crisis is similar, in certain ways, to the 2008 financial crisis, its resolution won’t be. At this point, Europe’s endgame — which is going on now — is closer to the 2011 debt-ceiling crisis. The problem is not that Europe’s governments or its central bank lack the resources to end the runs or fill the holes. It’s that Germany and the European Central Bank are using the threat of economic armageddon to force a sweeping package of reforms on the euro zone. Either their demands will be met and they will act to end the panic, or the two sides will deadlock and an unnecessary financial crisis will sweep across the globe.

In a Thursday speech before the European Parliament, Mario Draghi, the president of the European Central Bank, was clearer on this point than he has been in any public statements to date. “What I believe our economic and monetary union needs is a new fiscal compact — a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made,” he said. If that condition were fulfilled, then “other elements might follow.”

Bond markets breathed a sigh of relief. “Draghi is saying, pretty explicitly, that the ECB and the Germans are demanding changes in the way the other Europeans behave, especially on fiscal policy and structural labor reforms,” said Joe Gagnon, a senior fellow at the Peterson Institute for International Economics. “If those countries deliver, then the ECB will have to rescue them. If you tell someone they have to do something and they do it, you have to reward them. Because if you don’t, why would they ever do what you say in the future?”

To understand why Germany and the European Central Bank have taken a solvable financial crisis and turned it into an existential political crisis, it’s crucial to understand the flaw that the past few years has uncovered in the euro zone.

America’s debt bubble was inflated by the market’s confidence in institutions that were too big to fail: Goldman Sachs, AIG, Fannie Mae, Freddie Mac and others. Europe’s debt bubble was inflated by the market’s confidence that the euro zone was too hard to unwind. There were no provisions for a country to exit the compact. In addition to the ideological and political investment they had made in the monetary union, the technical challenges of pulling out were insurmountable: There would be bank runs and legal challenges and debts denominated in the wrong currency. It would be suicide.

Some wags joked that the euro zone was like Hotel California: You can check out anytime you like, but you can never leave.

The market acted accordingly. As recently as 2008, investors were willing to buy Greek debt at the same interest rates they charged for German debt. On the face of it, that seems absurd. But Greece was part of the euro zone. It would always be part of the euro zone. And so if it ever got into trouble, investors assumed it would be protected by the richer, more stable members of the euro zone. It was the Fannie Mae of Europe.

Rather than treating the members of the euro zone like individual countries that posed individual risks, the market treated them all like Germany, because the market assumed they were backstopped by Germany and, ultimately, the ECB. The current crisis is the market waiting for Germany and the ECB to clarify whether that is, in fact, true.

But Germany and the ECB won’t say that the euro zone enjoys their unconditional backstop unless the rest of the euro zone agrees to rules that the Germans and the ECB feel make that backstop sustainable. As in America’s debt-ceiling debate, they are risking an unthinkable financial — and political — crisis to fix what they see as fundamentally unsound economic policies.

That’s a hard sell to the Southern Europeans. German rules work for the German economy, which has in fact been helped by being tethered to the euro. The weak countries in the euro zone keep the euro cheaper than an equivalent German currency would be, which keeps German exports cheap and the German economy healthy.

But that’s meant Southern Europe is tied to a more expensive currency than would otherwise be true, and so it’s harder for those countries to fuel their economies through exports and balance their books. “There’s no obvious way for Southern Europe to grow, and if they can’t grow, they can’t balance their budgets, no matter how much austerity they engage in,” says Austan Goolsbee, an economist at the University of Chicago’s Booth School of Business.

Either way, Draghi’s admission of the ultimate deal clarifies the choice before Europe and moves us into what is likely to be the final act of the play. “I think we’re in the endgame here in the next three weeks,” Gagnon says. “Either they don’t deliver what the ECB wants and it all blows up, or they do deliver what the ECB wants, and they all get bailed out.”

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