Why Can’t an EU Member go Bankrupt?

I have repeatedly heard in the press that if a European Union (EU) member defaults on their debt they will be kicked out of the EU. But is this correct?

The EU’s economic framework is based off the Maastricht Treaty. In the Maastricht Treaty there are four main economic policies a EU member must follow to stay a member of the EU.

1. Exchange Rate Policy – The members must maintain a strict exchange rate in the market for 2 years prior to joining the EU.
2. Inflation Rate – The members must try to have no more than 1.5% higher inflation rate over the bottom three lowest inflation countries in the EU.
3. Long-term Interest Rates – Nominal Interest rates must not be more than 2% higher than the lowest three EU members inflation rates
4. Government Finance

• Annual Government Debt cannot exceed 3% of the GDP of their country
• Government Debt Ratios to GDP cannot exceed 60% of the member states’ GDP

Items 3 and 4 on the list imply issues with regards to bankruptcy by the nature.

• If you debt ration does not exceed 60% of GDP chances are you will not be filing for bankruptcy because your sovereign house is probably in order.

• If you do not run an annual budget deficit larger than 3% of your GDP you are probably not a candidate for bankruptcy

• If you are close to bankruptcy your nominal interest rates are most likely going to exceed the 2% above the three lowest inflation member states.

Nothing in the treaty specifically says a member cannot file for sovereign bankruptcy. If you look across the EU there are many EU members that do not meet items 3 and 4 today and have no way of meeting them in the future without filing bankruptcy. I would argue that once a member state exits bankruptcy they will be more apt to meet all the requirements. Imagine when Illinois and California have to file bankruptcy in the coming years. Will the US kick these states out of the US and not let them use dollar bills? NO! The only thing a sovereign bankruptcy does is it allows a country or state to reorganize their obligations to others to a more manageable number.

The way I see it, there are many economic benefits to the Euro in the form of trade and movement of individuals. If you combine this with the same currency covering over 500 million people, thus gaining critical mass, and you have a viable reason to remain a member. Because Greece, Ireland, Portugal, and Italy will eventually need to file for bankruptcy it does not mean they should have to leave the EU or stop using Euro’s. I say let them file today and in two years most of those locations will be in growth mode.

Full Disclosure

I do not own the Euro or any bonds in any of the countries or states mentioned.