Will the euro zone survive in its current form? To address this question, we need to consider three more precise issues.
First, how likely is a wave of sovereign defaults? Second, will the euro zone make the changes needed to prevent these? Third, could the euro zone survive them? My answers, in turn, are: quite likely; probably not; and perhaps – but not with certainty.
What has been happening is familiar to experts on emerging countries: this is a “sudden stop”.
Before 2007, credit was available on easy terms to fund asset price bubbles, construction and consumption, private and public.
Then, suddenly, markets shifted towards sobriety: funding dried up, house prices collapsed, construction crashed, governments guaranteed the debts of raddled financial systems, economies slumped and fiscal deficits exploded.
As Carmen Reinhart of the University of Maryland and Harvard’s Kenneth Rogoff noted in a paper released early this year, “in a crisis, government debt burdens often come pouring out of the woodwork, exposing solvency issues about which the public seemed blissfully unaware”.
So it has been in the euro zone periphery. Greece hid its true fiscal position. In Ireland and Spain (as in the US and UK), the boom covered up vast contingent fiscal liabilities.
Also striking has been how closely the riskiness of banks correlates with that of sovereigns. The latter are in trouble partly because some banks are too big to fail and too big to save. The question is whether these countries can avoid sovereign debt restructuring. On this, Prof Rogoff, a former chief economist of the International Monetary Fund, is gloomy.
In a recent note, he argued that “ultimately, a significant restructuring of private and/or public debt is likely to be needed in all of the debt-distressed euro zone countries".
"Already facing sluggish growth before fiscal austerity set in, [Portugal, Ireland, Greece and Spain] face the prospect of a ‘lost decade’, much as Latin America experienced in the 1980s," he said.
"Latin America’s rebirth and modern growth-dynamic really only began to unfold after the 1987 ‘Brady Plan’ orchestrated massive debt write-downs across the region. Surely, a similar restructuring is the most plausible scenario in Europe,” he argued.
Why might one be this pessimistic? The salient characteristic of lending to sovereigns is the absence of collateral. Thus, the safety of the creditors depends on their ability to sell debt to others at reasonable prices. If this confidence disappears, liquidity dries up and sovereigns are driven into default.
What, then, determines confidence? The short answer is: sustainability.
That itself depends on the relationship between prospective economic growth and the real rate of interest.
The lower the growth and the higher the interest rate, the bigger the primary fiscal surplus (before interest payments) needs to be – and so the greater the political costs of achieving it.
The bigger these costs, the less confident will investors be and the higher the interest rates will become.
This, then, creates a vicious spiral. Vulnerable peripheral euro zone member countries now suffer from troubled financial systems, high fiscal deficits, rapidly rising ratios of debt to gross domestic product, elevated interest rates, poor prospective growth and the absence of a central bank that is sure to make the debt market liquid.
Poor growth prospects, in turn, are partly due to loss of competitiveness. If these indicators were applied to normal emerging countries, a default would seem inevitable.
This leads us to the second question: will the euro zone make the changes needed to prevent defaults? The answer is: probably not.
One reason is that the creditors want them.
True, Germany has suggested this should apply only to future debt. But, in capital markets, the future is always now.
Moreover, the funds now on offer are not enough to finance all weak countries for long enough to avoid defaults, particularly since the latter will need to deflate and restructure their way back to growth.
As Desmond Lachman of the American Enterprise Institute argued in a recent paper for the London-based Legato Institute, prospective growth is of the essence.
But, in the absence of exchange rate flexibility and in the presence of high interest rates, cutting fiscal deficits on its own may well exacerbate slumps.
This leads to my final question: could the euro zone survive a wave of debt restructurings? Here the immediate point is that the crisis could be huge, since one restructuring seems sure to trigger others.
In addition, the banking system would be deeply affected: at the end of 2009, for example, consolidated claims of French and German banks on the four most vulnerable members were 16 percent and 15 percent of their GDP, respectively.
For European banks , as a group, the claims were 14 percent of GDP. Thus, any serious likelihood of sovereign restructuring would risk creating runs by creditors and, at worst, another leg of the global financial crisis.
Further injections of official capital into banks would also be needed.
This is why the Irish have been “persuaded” to rescue the senior creditors of their banks, at the expense of the national taxpayer.
Yet even such a crisis would not entail dissolution of the monetary union. On the contrary, it is perfectly possible for monetary unions to survive financial crises and public sector defaults.
The question is one of political will.
What lies ahead is a mixture of fiscal transfers from the creditworthy with austerity among the uncreditworthy. The bigger are the former, the smaller will be the latter.
This tension might be manageable if a swift return to normality were plausible. It is not. There is a good chance that this situation will become long-lasting.
Still worse, once a country has been forced to restructure its public debt and seen a substantial part of its financial system disappear as well, the additional costs of re-establishing its currency must seem rather smaller.
This, too, must be clear to investors. Again, such fears increase the chances of runs from liabilities of weaker countries.
For skeptics the question has always been how robust a currency union among diverse economies with less than unlimited mutual solidarity can be.
Only a crisis could answer that question. Unfortunately, the crisis we have is the biggest for 80 years.
Will what the euro zone is able to agree to do be enough to keep it together? I do not know.
We all will, however, in the fairly near future.