The countries in Europe have different productivity. Germany is large and near the top, Greece has a lot of debt and is near the bottom in productivity. With an open market and easy credit, the mismatch in productivity produces a trade imbalance within the EU, and that accumulates as debt. Poor Europe buys goods from rich Europe partly on credit.
Assuming things remain constant, this credit is nominal only – it’s to keep trade flowing and will never be repaid. This is usually OK. Sovereign debt is usually permanent, and it’s really a monetary instrument (bonds are a kind of slow money) rather than a cashflow debt that’s expected to be repaid. The market will sustain the debt if it matches the pace of growth, so that the debt to GDP ratio is roughly constant. If debt grows much faster than GDP the market gets jumpy and starts perceiving sovereign debt as ordinary cashflow debt, and we get the current mess.
What, then, is to be done? Europe as a whole has three options:
