It is interesting to note the continuing struggle between EU leaders regarding the debt crisis. For example, the recent fiscal compact is a perfect example of the battle between politicians to push their ideas regarding how to restore confidence.
Not Debt But Confidence
For some background, it should be said that the crisis in Europe is not about debt but market confidence.
The problem is not that Southern European countries have high debt, but that investors do not believe these countries can manage their debt. For instance, UK Chancellor George Osborne has had incredible success creating market confidence in him, in spite of the fact that Britain has comparable debts to France. Interest rates on British government bonds are at all time lows while those of France remain perilous. This is in large part because Osborne has kept to his single line about cutting public spending.
Hence, the European crisis is not a debt crisis but a confidence crisis. Given this, the problem for Europe is not how to reduce debt per se but how to restore confidence, so that countries can borrow at reasonable rates. There are two lines of thought regarding this.
Confidence Through Cutting Spending
The first line of thought concerns increasing confidence through cutting public spending.
This is the method favoured by Germany, and that reflected in the recent fiscal compact. The idea is that once the market sees national governments taking active steps to reduce their public debt, confidence will be restored. In fact, given the success George Osborne has had using this method, it is a reasonable assumption.
But there are problems herein. For one, as Mr. Osborne is finding out, cutting spending might restore confidence, but it does not spur growth. Britain declined -0.2% in Q4 2011 while unemployment has steadily risen. Hence, if this policy were implemented across the continent, something comparable might soon occur.
Confidence Through Transfer Union
The second line of thought concerns transferring funds from the solvent North to the struggling South.
This method has French support, and is reflected in the existence of both the EFSF and ESM rescue funds. The idea (simply enough) is that the markets need not be concerned about borrowing from Spain or France because, in the event they default, Germany will pick up the tab! It is a permanent transfer union in all but name.
The trouble with this of course is that the population of Germany do not want to pay for the debts of Southern Europe! To advocate this is political suicide, and the reason Chancellor Angela Merkel has pushed the fiscal compact upon the EU.
Two Solutions In Tandem
Of course, at present, these two solutions exist in tandem. The French and Italian leaders push to expand the EFSF rescue fund, at the arguable expense of the German people. German leaders meanwhile push greater public spending, at the arguable expense of the populations of Spain and Greece.
Looking ahead, the question is which will conquer!