Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)

I think about European sovereign debt in somewhat similar terms, but I want to elaborate on Davies’s framework a little.

First, refusing to pay up and paying up in inflated currency are both forms of default. The fact that EU member states cannot print the Euro therefore changes the form of the risk of default.

Second, the form of the risk of default matters. Think about the payout of a security under variable outcomes. When the outcome is very good, the security pays out a high amount, and when the outcome is very bad, the security pays out very little. We can imagine that in the middle of the outcome spectrum, there are a number of possible payout profiles. You can have payouts vary smoothly with outcome, or you can have a tipping point, above which the payout is high and below which the payout is low. When payouts vary smoothly with outcomes, the price of the security is not going to be very volatile. When payouts vary sharply with outcomes, the price of the security may be highly volatile when outcomes may fall on either side of the tipping point. I think this is what Nassim Taleb means when he says that debt is fragile and equity is robust: debt payouts vary sharply with outcomes and equity payouts vary gradually with outcomes.

Third, when a government can inflate away part of its debt, the real, inflation-adjusted payout can vary more smoothly with outcomes. This makes the debt a little less like debt and a little more like equity. When a government cannot inflate away its debt, the price of its securities are going to be very volatile around the outcome tipping point.

Fourth, since EU governments cannot inflate away their debt, the risk premia on their bonds are going to take a highly volatile form. This is going to lead to frequent debt crises unless the governments are highly responsible and avoid landing anywhere near the outcome tipping points.

Davies concludes his post with “Something, somewhere has to give.” I think that what has to give if people want to preserve currency union is that member countries are going to have to accept balanced budget requirements as the US states have. But at the same time, I am skeptical that the southern European countries can really be counted on to abide by such requirements if they are imposed. They failed to keep their deficits within the 3% of GDP limit the EU treaties currently require, and they have been and are going to be rewarded with bailouts.

Many commentators are talking about fiscal union, which is perhaps a subject for another post, but I am not too enamored of this option as it has many public-choicy downsides. Probably the thing to do, though difficult, is to give up on the common currency and instead focus on creating the largest free-trade and free-movement zone in the world. That is the robust road to prosperity.

• The right model for thinking about the Greek government’s large and chronic deficits is the budgetary or fiscal commons. Richard Wagner says it well (in the context of the US government): “Most collective or corporate organizations, profit-seeking and nonprofit, do not suffer from continued deficits. What distinguishes the federal government from other corporate bodies is that the federal budgetary process illustrates the ‘tragedy of the commons.’ The federal budgetary process is a natural product of common property budgeting, where choice is divorced from responsibility for the consequences of those choices.” Interest groups within Greece compete for tax revenue, knowing that if they abstain, someone else will benefit from their abstemiousness. This leads to “overgrazing” of the budgetary commons, or chronic deficits.
• By bailing out Greece, other EU governments are extending the range of the commons. They are further divorcing choice and responsibility for decision-makers in Greece and in other profligate member governments.
• A Greek default need not harm the Euro very much. The strength of the Euro depends most heavily on the willingness of the European Central Bank to keep inflation low, and much less on Greece’s finances. If Greece’s default causes a debt crisis in Spain, Italy, and Portugal, this could eventually weaken the Euro as the ECB would be expected to apply monetary stimulus. But letting Greece default could also force those other governments to take their finances more seriously, and in any case, the principle of triage applies to bailouts as well as medicine.
• If the Greek government is not bailed out, as is my preference, things will sadly be very, very bad for Greece. Creditors of the Greek government would have to take a haircut; there would be no way around that. The Greek economy would suffer a long and deep depression. This would be painful for the Greek people, but the goal is to prevent something worse from happening down the road.
• Greece should never have joined the Euro because they now have no control over monetary policy. When people discuss so-called “optimal currency areas” they rightly emphasize labor and capital mobility, and factors which affect these. Perhaps one underappreciated additional issue is fiscal responsibility. If one government in a currency union is relatively fiscally responsible and one is not, then the responsible one will always be called upon to bail out the irresponsible one. If the bailout occurs, this is bad because it extends the fiscal commons, as discussed above. But if the bailout does not occur, the irresponsible government is harmed by more than it would have been if it had its own currency and monetary policy. Note that this logic applies to currency pegs as well, as Argentina learned.
• It is dangerous to anthropomorphize governments, but putting this concern aside, the right metaphor for better policy is not “austerity” but “enlightened self-interest.” The key question facing the Greek government is Can you solve the fiscal commons problem? Solving a commons problem is not about ascetic self-denial, but about far-sighted self-improvement: building the institutions that will make the country better off in the long run.
• In general, I think it would be a good thing if investors looked at sovereign debt more skeptically. First, sovereign debt is subject to the “Black Swan” problem. Second, bond markets are one of the major constraints governments face. (As James Carville said, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”) It would be better if the bond market intimidated the government sooner rather than later on the road to insolvency.
• I worry a lot about a US sovereign debt crisis. With such a big economy, the fiscal commons problem is in many ways more severe. I think Congress could overcome the commons problem in order to avoid a debt crisis, but debt crises have a very quick onset. By the time people realize it is happening, it may be too late.