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"; breakup, 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 as 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.
The first institutional reform takes the form of a larger envelope of official resources, which would mean a quasi-fiscal union. Official resources currently are sufficient to bail out Greece, Ireland, and Portugal but not to prevent a self-fulfilling run on the short-term sovereign and financial liabilities of Spain and other potentially distressed eurozone members. So even if these countries were to implement the necessary fiscal and structural reforms, an increase of official resources would nonetheless be needed. Because nervous investors don't want to be last in line in case of a run, a disorderly rush to the exits is likely when official resources are insufficient.
Short of full fiscal unification—or a variant of it in the form of eurozone bonds—this increase in official resources would occur through a much-enlarged European Financial Stability Facility and a much greater commitment by the European Central Bank to long-term bond purchases and liquidity operations to support banks. Since quasi-fiscal union implies that the eurozone's core economies could end up systematically bailing out those on the periphery, only a formal loss of fiscal sovereignty—a credible commitment by the peripheral countries to medium- and long-term fiscal discipline—could overcome the current political resistance of Germany and others.
But even a larger envelope of official resources is not sufficient to stem the insolvency problems of Greece, Ireland, and, possibly, Portugal and Spain. Thus, a second set of policies and institutional reforms requires that all unsecured creditors of banks and other financial institutions need to be "treated"—that is, they must accept losses (or "haircuts") on their claims. This is needed to prevent even more private debt being put on government balance sheets, causing a fiscal blowout. If orderly treatment of unsecured senior creditors requires a new cross-border regime to close down insolvent European banks, such a regime should be implemented without delay.
Similarly, super-sovereigns cannot continue to bail out distressed sovereigns that are insolvent rather than illiquid. Thus, in addition to an orderly resolution regime for banks, Europe must also implement early orderly restructurings of distressed sovereigns' public debt. Waiting until 2013 to implement these restructurings, as German Chancellor Angela Merkel proposes, will destroy confidence, as it implies a much larger haircut on residual private claims on sovereign borrowers.
Orderly market-based restructurings via exchange offers need to occur in 2011. Such exchange offers can limit private creditors' losses if they are done early. That way, formal haircuts on the face value of debt can be avoided via new bonds that include only a maturity extension and an interest-rate cap that is set below today's unsustainable market rates. Waiting to restructure unsustainable debts would only lead to disorderly workouts and severe haircuts for some private creditors.
Finally, Europe needs policies that restore competitiveness and growth to the eurozone's periphery, where GDP is either still contracting (Greece, Spain, and Ireland) or barely growing (Italy and Portugal). Without growth, it will be difficult to stabilize public and private debts and deficits as a share of GDP—the most important indicator of fiscal sustainability. Moreover, without growth, the social and political backlash against painful belt-tightening will eventually undermine austerity and reform.
Unfortunately, fiscal austerity and structural reforms are—at least in the short run—recessionary and deflationary. So other policies are needed to restore growth. The ECB should pursue a much looser monetary policy to jump-start growth, with a weaker euro to help boost the periphery's competitiveness. In addition, Germany should delay its fiscal consolidation; if anything, it should cut taxes for a couple of years to boost its own growth and—via trade—that of the periphery.