The endgame for Europe's debt crisis will not be the destruction of the euro.
The project of monetary unity has too much elite political support in the euro-zone countries. They just will not let it be destroyed by the bond market.
That means it is time to start thinking about the likely course the Europeans will take to avoid an existential crisis.
In the first place, an existential crisis is possible. Greece will almost certainly default at some point. That default will be a catalyst for the realization that sovereign debtors in the euro zone can indeed default and that there is no mechanism in place to avoid default.
Dominoes will start falling. Private investors will flee from one or more public bond markets. Places like Italy, Ireland, Spain and Portugal will find it difficult to borrow at sustainable interest rates. At some point, interest rates will get so high that more defaults will be triggered as countries are unable to roll over old debt to new. As Wall Street Journal columnist Holman Jenkins points out, even Germany could lose access to private markets at some point.
But the domino effect could be stopped by adopting a simply policy of interest rate targeting by the European Central Bank. The ECB could simply declare that certain countries—perhaps everywhere that isn't Greece—are in a "zone of protection." For countries within that zone, the ECB would adopt a policy of not permitting interest rates to rise above a certain level. When private markets attempt to push rates higher, the ECB would simply buy the bonds itself with newly created money, reducing rates to within the official boundaries.
In other words, the ECB would act like a central bank of a sovereign nation that creates its own currency. Like, say, the Federal Reserve .
This scenario seems more likely than an explicit backstop of European sovereign bonds or a replacement of sovereign bonds with Eurobonds.
Either of those would be politically costly and difficult to coordinate. Both would probably wind up being ineffective because they would probably come with limitations as to their size, which would immediately be tested by the bond markets.
Concerns about moral hazard could be addressed simply by tying the interest rate boundaries to debt levels. A country that attempts to run up a debt beyond a level deemed acceptable by the central bank could have its interest rate hiked, making it absorb some of the cost of its borrowing.
Would this process be inflationary? Of course it would—but only in the strict sense that it would result in inflation in the supply of money. But since much of Europe seems to be sliding into a recession, it wouldn’t necessarily result in immediate price inflation. We’ve seen the Federal Reserve has been able to dramatically increase its bond buying without triggering runaway price inflation .
This kind of interest rate fixing below the market price would, of course, distort market processes. It is central planning for interest rates—there’s no getting around that. This distortion will no doubt warp the economies of European nations in undesirable ways. But it would probably save the euro.
I’m not sure the euro is worth saving, in the end. It always seemed to me a Trojan Horse for centralization of European political power.
But I am sure the political elite of the euro zone are convinced the euro is worth saving. Which is why I think the ECB will eventually start acting like the Federal Reserve of Europe.
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