What Europe Can Learn From America

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Why can’t Europe be more like America, where the debt problems of Illinois or California could never threaten a breakup of the entire Union? Not so in Europe, where the problems of tiny Greece have set off a financial storm that is now threatening the entire dysfunctional EU, engulfing Italy and even exposing cracks in France and Germany.

Italy was only saved from out-of-control interest rates on its mountains of government debt by the European Central Bank’s emergency bond-buying last week. France is now widely considered next in line after the U.S. to lose its AAA bond rating. Even Germany, the most rock-solid of the West’s major economies, no longer looks invincible. Since July, the cost to insure German government bonds against default has doubled, and now exceeds that for British bonds for the first time in living memory.

Amid wildly gyrating markets, the leaders of Germany and France, Angela Merkel and Nicolas Sarkozy, met for an emergency crisis summit at the Elysee Palace in Paris on Wednesday. The result — drum roll, please — was a few meaningless platitudes about the euro being “part of our health and peaceful coexistence,” vague plans for an EU-wide financial transactions tax, and a promise to create yet more jobs for French bureaucrats in a soon-to-be-formed “Eurozone Council.”

Such verbiage and dithering in the face of market mayhem helped Europe get into its mess in the first place. You might remember this same duo reacting to the first near-meltdown over Greece in May 2010 by insisting that bankrupt Greece would never be bankrupt, lashing out at foreign “speculators”, and banning short sales of stocks and bonds. Then, as now, the markets’ reaction was to keep falling.

To suggest Europe needs to adopt a dose of American federalism to get its crisis under control might be hard to swallow given America’s own serious problems, not least the sad spectacle of a polarised Congress taking the country to the brink before agreeing on some first baby steps in attacking the country’s ballooning debt.

But the idea is this: If only these countries took a big step forward toward a true United States of Europe, settling their ancient grievances to create a stronger union in which rich Germans and Dutch shared their wealth with the less fortunate Greeks and Italians, then these crises would be a thing of the past.

Economists call this a “fiscal union,” a key part of which is that all the countries using the euro share joint responsibility for each other’s debt and finances by issuing a common “Eurobond.” These Eurobonds would be guaranteed by all 17 countries using the euro so no individual state can go bankrupt, and future crises like Greece’s are avoided.

The “fiscal federalists” are probably right that Europe could use a few lessons from America, whose 50 disparate states have long lived in a currency union. But the lessons American federalism can teach the Europeans may not be what the supporters of more European integration usually have in mind.

America’s federalism works precisely because there are no bailouts between the states. As the economic historian Michael Bordo explains, there was a time when U.S. states regularly ran up out-of-control debts in the expectation that Washington would bail them out. It was only after a wave of state bankruptcies in the 1840s (after Washington said, ‘sorry, no bailouts’) that the states shaped up and institutionalized tough balanced-budget rules, which 36 states have today and which have prevented the worst excesses. So it was no surprise in 2009 when Obama said ‘no’ to a bailout out for California—nor that Californians declined to trash the streets of Sacramento and call Obama a Nazi for not paying their debts, as many Greeks are insulting Angela Merkel now.

Or take the exceptional bailout of New York City in 1975 (which Gerald Ford, playing the role of Merkel, first rejected before approving with tough conditions). The U.S. federal government and New York State forced a financial control board on the city that enacted deep cuts in services, reorganized the budget process, and instituted several years of oversight. Compared to such tough love, Greece is still getting the velvet treatment, and has barely begun the necessary reforms.

Europe’s current troubles started in 2010, when its leaders began to bail out Greece without any plan for dealing with the insolvent country’s vast overhang of debt, worth over 160 per cent of GDP and made unsustainable by a deeply uncompetitive, import-dependent economy and a society addicted to government largesse but refusing to pay taxes. The bailout followed earlier implicit promises that no creditor to any European bank or country would ever have to write off debts. Investors quickly looked at all the other countries with shaky banks and big national debts, put two and two together, and drew the inescapable conclusion that Europe’s politicians were bluffing.

It was only on July 21 of this year, after more than a year of bickering (mainly over Germany’s insistence that the banks who’d recklessly lent to Greece and others share the burden with Europe’s taxpayers), that Europe got some of the building blocks in place that could help it get out of the crisis. One is an end to total and open-ended guarantees. Banks will now be forced to restructure the debt and take part of the losses. That can be a model for sharing (and thereby limiting) bank and taxpayer losses on other present and future debt, says Berlin bond-market expert Achim Duebel. Second, the ECB can now intervene in the bond markets to lower interest rates for countries like Italy, which is basically solvent. Third, Europe has a new rescue fund that, while not big enough at the moment, could be turned into a European version of the IMF–a model just proposed by Thomas Meyer, chief economist of Deutsche Bank, and Daniel Gros, director of the centre for European Policy Studies in Brussels. For the first time now, this EU-wide fund can recapitalize banks, attacking another crucial source of continued European dysfunction.

Eurobonds, which Merkel and Sarkozy insisted are off the table for now, would create more problems than they would solve, argues Duebel. One widespread proposal is for each country to be permitted to issue jointly guaranteed Eurobonds up to a certain limit, such as 60 per cent of GDP. If a country wants to splurge, it will have to raise additional funds on its own, at whatever interest rate it can get on the market. So far, so good. But the model seems guaranteed to crash in a crisis, when government debt suddenly explodes because of bank bailouts, for example. To think that a government like Greece’s can then raise all that extra debt on its own in a freezing market is wishful thinking, says Duebel. It’s a recipe for more EU bailouts. Instead, Duebel proposes the EU jointly guarantee a fraction of each bond that would give investors a limit to their losses, like the 50 per cent guarantee they’re getting on Greek bonds now.

As Germany is finding out, guaranteeing Greek and Italian debt comes with tremendous, possibly existential political risks, not least a backlash among rich-country voters. And this is perhaps the main reason why Europe can’t just act like the United States. The EU is a gradual construction that has to manoeuvre around ancestral obstacles; psychologically, most European countries aren’t really republics at all but in many ways modern tribes, each with different languages, ethnicities, cultures and historical memories. The German tribe doesn’t want to pay the debt of the Italian tribe, and the proud and ancient tribe of Greece takes no orders from those upstart chieftains of Germany. Europe’s last attempt to forge a more perfect union once and for all, a grand constitutional convention from 2001 to 2003 that evoked America’s own convention in 1787, ended in disaster, with voters in Holland, France and elsewhere rejecting the 465-page document.

The EU has tamed these ancient tribalisms in fits and starts. That there has been only one genocidal war on this blood-drenched continent since 1945 (the Balkans conflict in the 1990s, which, tellingly, the U.S. had to come in and end) is in itself an astonishing success. The best and most realistic hope is that the EU will once again muddle through as it always does. Just don’t expect silver bullets or clean solutions–and pray that this won’t be another case, like the Balkans, where Europe can’t help itself.

This post originally appeared on The Daily Beast.