If Italy Goes, So Does the Euro

So much for good intentions. No later than two years after the common currency’s launch, the two largest eurozone members, Germany and France, violated the deficit criteria. Although Germany corrected its behavior later on, a terrible example had been set. The ECB, too, became politicized, and the dam broke.

More and more members embarked on unsustainable growth strategies financed with low-cost debt while expanding oversized welfare programs. Political parties bought votes with debt-financed gifts. Next, to forestall inevitable bankruptcies, the ECB betrayed its mission and engaged in such rule-bending schemes as zero-to-negative interest rates and “quantitative easing” to shore up the troubled eurozone governments.

Essentially, the ECB became involved in the bailout that was never supposed to happen anyway, prohibited by the rules of the game. It even bought debt securities of troubled countries and to this day has the Greek banking system on life support.

Several European countries lament the competitive edge enjoyed by some countries in the north, and especially by Germany’s export sectors. It is true that the euro has proven highly beneficial for Germany and the Netherlands, which steadily increased their productivity and kept a lid on public spending.

The countries that took advantage of abundant “hard” currency are in a fix today that reveals the scope of the problem for all. The bill for the spenders’ profligacy shows in the target balances of the ECB, where the amount due to Germany approaches a trillion euros—unpaid and practically unpayable.

At this point, all of the correct solutions appear unthinkable, too painful to the interested parties. But as responsible and realistic individuals, we need to face the scenarios—bitter as they may be—and try to make the best choice.

One such solution would be to allow member countries to leave the euro and go bankrupt. This is the simplest way out, albeit with grave consequences to all debt holders who trusted the governments and rating agencies—even after the triple AAA ratings and mathematical models of these agencies proved worthless in the 2008 financial crisis. Under this scenario, the broke governments would need to sell quite a few of their assets to the private sector or pension funds and subject themselves to stricter spending discipline (increasing taxes is certainly not the right way to go).

But bankruptcies and leaving the eurozone are tough measures, difficult to entertain. In the long term, however, this is the best solution. It offers the only sure path to restoring vibrant economies, solving the liquidity problems, and easing the social tensions. Such a cure also would be less damaging for Europe’s global position than any alternative.

Another possible way to go, also politically difficult and considered “unthinkable” for various reasons, would be to split today’s eurozone into two parts. Germany and other highly productive northern countries like the Netherlands could leave the euro and create a “hard” currency system of their own.

The remaining eurozone members, including big countries such as France, Italy, and Spain, soon would see their euro weaken, their competitiveness improve, and the total sum of their debt decrease.

The approach has several drawbacks. The northern bloc countries would find themselves under even harsher pressure to ramp up their productivity (to remain competitive despite their very strong currency). On top of that, the “northerners” would still need to write down a big part of the receivables from foreign government debt and the ECB.

Also, the split would send an ominous signal about the prospects of the EU’s internal market, not to mention the “political union” project. Worst of all, it again could create the wrong incentives for fiscally irresponsible governments.

Although this script may seem quite far-fetched, it has a chance of becoming a reality. At the moment, though, it looks like it’s muddling through as usual, for as long as possible.

This is irresponsible: If the eurozone countries fail to address their biggest problem, they may quickly get caught on the wrong foot by a sudden political crisis or global economic slowdown.