Righting the Ship
So the euro is now at a crossroads, and important decisions must be taken. Preserving the eurozone -- as it is now -- might be workable if it were possible to transform the region into a full fiscal union where budgetary policy was coordinated across countries by a central treasury, in much the same way as is done in the United States. But such an arrangement is now a political impossibility, as Europe's core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbors.
With fiscal union off the table, there are basically three possibilities. The first is to stay more or less where we are, expanding the ECB's bond-purchasing program and simply trying to hang in there. The stability fund could be increased, but the more numbers start being accounted for in detail, the further away the various parties get from being able to agree. If this continues, the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, because the bank takes the view that the resolution has to come from the politicians.
But with Italy and Spain's combined sovereign refinancing needs between now and the end of 2012 totaling about 660 billion euros, and given the financing needs of the banks on top of this figure, reaching agreement to expand the bailout mechanism looks pretty improbable, especially when one considers that there's no turning back once it starts. So, at some point, the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed toward the brink of breakdown.
The second possibility would be to disband the union entirely, leaving each member to go back to its national currency. This would be a disastrous outcome for all concerned and for the global financial system. Coordinating the unwinding of cross-country counterliabilities would be a nightmare given the level of interlocking corporate and sovereign bond markets. The sudden disappearance of one of the major global currencies of reference would also cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is happening to gold, the Swiss franc, and the Japanese yen to catch a glimpse of what would be in store. Of course, this kind of violent unwinding would never be undertaken voluntarily, but that doesn't mean that it is impossible -- particularly if solutions are not found and the force of market pressure continues.
Fortunately there is a third alternative: The eurozone could be split in two, creating two separate (and unequal) euro currencies. Naturally, the composition of the groups would be a matter of negotiation because some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, the Netherlands, and Austria. It might even take Estonia, which has been making it pretty clear that it would also be up for the ride. Spain, Italy, and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.
The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. If such a plan meant not ultimate divorce but temporary separation, then French participation with the southern economies would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.
Naturally, the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is laboring -- the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants -- would be resolved at a stroke.