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There was some excitement Monday over the announcement that Merkel and Sarkozy have decided that the European Union treaty needs to be rewritten to include sanctions on countries that exceed the 3% debt/GDP limit that they all agreed to way back when the EU was first established.

The problem with this "solution" is that the mechanism for enforcing sanctions is a deeply flawed concept. The best, and probably the only way, to impose real sanctions on governments who spend and borrow too much is to let the market do it. When the yield on your bonds starts to skyrocket, you quickly realize that you can't continue to borrow. You either mend your ways and borrow less, and/or figure out how to grow more, or you default on your debt obligations. And even if you default, you will find it very difficult—if not impossible—to continue to be profligate. That's the way it has always worked in the bond market. It's quite simple: if lenders don't think you can repay your debts, they won't lend you any more money.

A market-based solution doesn't need any agreements or rewritten treaties. It also has the virtue of essentially eliminating moral hazard, since lenders would have a powerful incentive to do their due diligence every time they buy a bond, instead of simply relying on what ratings agencies are saying, or betting that they will be bailed out by taxpayers or other countries if things turn sour. A true market-based solution would even make the ratings agencies obsolete.

No serious investor would ever base his decisions on what a ratings agency says anyway; the only purpose that ratings serve in today's world is to facilitate the ability of bureaucrats and technocrats to decide, for example, which assets qualify as Tier 1 capital for banks, effectively overriding the investment decisions of the private sector and thus providing fertile ground for moral hazard.

The only reason that no one is talking about a simple, proven, market-based approach to solving the Eurozone sovereign debt problem is that politicians (urged on no doubt by their investment banking constituents) fear that highly indebted Eurozone countries are more likely to default (i.e., to act irresponsibly) than they are to cut spending, and that this, in turn, puts Eurozone banks (who hold tons of Eurozone sovereign debt) at risk, and that this, in turn, puts the very viability of the Euro and the Eurozone economies at risk. Politicians love to think this way, because it makes them indispensable. The truth, however, is that when politicians step into the fray to fix things, they almost always make the situation worse.

Eurozone countries may indeed default, and defaults may be large enough to bring down the Eurozone banking system, but a collapse of the Eurozone economies is not necessarily the only way this can play out. Defaults happen all the time. Banks fail all the time. Defaults don't destroy currencies, they just destroy the value of debt issued in that currency. Defaults don't destroy wealth, since they are just the accountant's way of recognizing economic realities. Defaults don't destroy demand either, since debt is a zero-sum game: one man's liability is another man's asset.

The value of global financial assets fluctuates by trillions of dollars every day and yet economic life goes on. There is a virtually unlimited supply of capital in the world ready to fund profitable new ventures and/or to recapitalize failed banks. Truth be told, the market has already wiped out almost 80% of the market cap of Eurozone financial institutions in the past four years, yet the Eurozone economies continue to function as always.

Will the politicians please stop trying to "fix" this Eurozone debt problem? A trillion or two of defaults might end up doing us all a world of good.

Source: The Solution For The Eurozone Debt Crisis Is Actually Quite Simple