Debt Restructuring Will Save the Euro
"The size of the financial envelope of the EFSF represents underwhelming force and far too small a bazooka to deter denial of market access to even the smallest sovereign borrowers," he wrote.
A break-up of the euro zone is highly unlikely, according to Buiter, but its likelihood could increase without the right reforms, which include debt restructuring.
He imagined four scenarios for the euro-zone's break-up: Greece being the only country to leave, Greece and other weaker members leaving, Germany and other strong countries exiting and a collective decision to dissolve the EMU altogether.
However, analysts agree that policy makers will do everything in their power to save the monetary union.
"The euro zone will survive," Schneider said. "In the spring of this year we'll see a stability mechanism that will foresee an institution of debt restructuring."
Orderly restructuring of debt is crucial to the survival of the single currency and it will have to take place, Buiter wrote.
"Despite the recent drama, we believe we have only seen the opening and second act (of the debt crisis), with the rest of the plot still evolving," he wrote.
Should Banks Pay?
In Buiter's opinion, Ireland, with its "too big to save" banks, is insolvent just like Greece with its spiraling debt, while Portugal is "quietly insolvent" at the current levels of interest rates and with its anemic growth.
To prevent disorderly, "involuntary" defaults, European policymakers will have to set up a clear way for restructuring sovereign debt once a new, permanent European Stability Mechanism is put in place when the EFSF expires in mid-2013, he wrote.
EU finance ministers refused, in a recent meeting, to commit to increasing the EFSF and for the moment all countries – even Greece – deny that debt restructuring will take place, although murmurs have started to appear.
Don't Touch the Banks?
Policymakers are taking into consideration all kinds of solutions to come up with the cash needed. One recent proposal suggested imposing a one-off tax on banks to fund the European Stability Mechanism.
But, as some analysts point out, this could actually exacerbate the problem since European banks are so exposed to the sovereign debt.
"The proposal … would be counterproductive," Schneider said. "Banks also need to be recapitalized. If you weaken the banking system, there will be spillover effects."
The European Central Bank's credibility, already hit hard, is likely to suffer further as it will keep its central role in fighting the crisis.
"With EU leaders unwilling to take action to cure the sovereign solvency issues, the burden to maintain stability within the euro zone rests entirely on the ECB's shoulders," Peter Vanden Houte, chief euro zone economist at ING, said.
Because of this, despite signs of rising inflationary pressures, it is very unlikely that the ECB will be raising the rates in 2011, Vanden Houte added.
What happens in Spain, the biggest of the euro zone periphery countries, is now crucial. Spain is, according to some analysts, the most solid and if it manages to make it through the market turmoil without a bailout, the crisis will likely be contained.
"Spain doesn't have such a competitiveness problem, doesn't have such a huge public debt problem," Schneider said. "If there is a need to recapitalize banks, they could cope with that internally."
"Politicians hope to draw the line in the sand before Spain," he added.