Europe's default in credibility: a cautionary tale of broken promises, misled markets, and a loss economically of simple common sense.

• Author: Lerrick, Adam

Once, the smart money was betting on a new economic geography where nations were united in regional alliances to share markets and monies. Now the Euro-Union's scramble to contain a self-inflicted debt crisis provides a cautionary tale of what happens to monetary union when promises are broken, markets are misled, and geopolitical dreams override economic good sense.

Sharing of tax rolls between profligate and prudent nations was never the intent of euro founders. But it became the de facto result when Greece became the first insolvent member of the monetary union. EU Commissioner Joaquin Almunia's pronouncement that "In the euro area, default does not exist," was backed up by an EU/IMF 750 billion [euro] fund that promised bailouts to any and all.

Bavarian business owners became unwilling co-signors on the unchecked spending and borrowing of their Athenian neighbors; the Greek people were denied a fresh start and stared ahead to a 25 percent drop in living standards and a decade of stagnation; and the euro was debased as an "independent" European Central Bank was stuffed with 76.5 billion [euro] of risky Greek, Portuguese, Spanish, and Irish government bonds. Market prices signaled that the Euro-Union had failed its first stress test.

Much has been made of Europe's current move toward fiscal union. But from its inception, a monetary union that forbade the transfer of debt from one national treasury to another had stumbled across the line. Members were bound to limit deficits to 3 percent of GDP and national borrowing to 60 percent of GDP. A watchdog European Commission would enforce compliance. This ad hoc performance guarantee homogenized credit risk just as the common currency homogenized foreign exchange risk. Now, all member debts were transformed into "virtual" Euro-Union bonds without the fine print.

Markets applauded and soon all of Europe borrowed at low German rates. Greece's five-year cost of funds fell from 8 percent above Germany in 1998 to a 0.5 percent spread in January 2001 when it joined the euro and down again to 0.2 percent from 2002 until 2008 (Figure 1). The fiscal illusion reduced the Spanish Treasury's borrowing bill by 8-10 billion [euro] every year.

While governments gorged on cheap debt, the overseers in the counting rooms in Brussels looked the other way. Rules without punishment for transgressors soon proved worthless. Even after a windfall of three years of revenue growth, seven of the euro's twelve members...