A Survival Strategy for the Eurozone

NEW YORK – After the Greek and Irish crises and the spread of financial contagion to Portugal, Spain, and possibly even Italy, the eurozone is now in a serious crisis. There are three possible scenarios: “muddle through,” based on the current approach of “lend and pray”; “break-up,” with disorderly debt restructurings and possible exit of weaker members; and “greater integration,” implying some form of fiscal union.

The muddle-through scenario – with financing provided to member states in distress (conditional on fiscal adjustment and structural reforms), in the hope that they are illiquid but solvent – is an unstable disequilibrium. Indeed, it could lead to the disorderly breakup scenario if institutional reforms and other policies leading to closer integration and restoration of growth in the eurozone’s periphery are not implemented soon.

The crisis started with too much private debt and leverage, which became public debt and deficits as crisis and recession triggered fiscal deterioration and private losses were mostly socialized via bailouts of financial systems. Then, distressed sovereigns that had already lost market access – Greece and Ireland – were bailed out by the International Monetary Fund and the European Union.

But no one will bail out these super-sovereigns if the sovereigns prove to be insolvent. Thus, the current strategy of kicking the can down the road will soon reach its limits, and a different plan will be needed to save the eurozone.