
The end of 2011 and early 2012 was one of the most stressful periods in modern European history. Even the otherwise composed German chancellor Angela Merkel was brought to tears.
At issue was the very survival of European Union which had once again gone into a recession, and financial markets were seriously doubting the viability of the European integration project. Spreads on Greek, Italian, and Spanish sovereign bonds reached historic highs, and their banking sectors were faced with the real threat of bank runs.
What had brought Europe to this precarious position? Why was the unity of Europe, a remarkable political and social achievement, in serious doubt?
The answer is debt.
In the years leading up to the Great Recession, the financial markets had reposed great confidence in the so-called “peripheral” economies such as Greece and Spain. Lenders from creditor countries such as Germany and the Netherlands were willing to lend to these peripheral countries at very low spreads by historical standards.
The result was a great run up in debt inside Europe between 2002 and 2008. The figure below summarizes the net borrowing / lending position of each European country on the horizontal axis. Each country is ranked on this axis by its average current . . .