What the End Game in the Euro Zone may Look Like

A headline says that an investment bank survey found almost half the respondents expect at least one country to drop out of the euro zone next year. This is twice the percentage of a couple of months ago. While such a scenario cannot be ruled out, cost/benefit analysis still argues against a country leaving.

Currency in Crisis

Greece is seen as the most likely candidate to leave, and some eminent minds argue it should. However, whatever benefits it may get by a devalued currency, assuming that it were to be accepted by businesses and consumers knowing full well it would not a store of value, would quickly be eroded by higher inflation, a deeper economic downturn, weaker export markets, a destruction of its banking system, not to mention escalating social tensions, which could undermine its political stability.

Moreover, an exit by Greece, for example, would not solve the institutional challenges, including the role of the ECB and private sectors in any adjustment process. In fact, a Greek exit could easily heighten the risk that another country leaves. Also if Greece were to drop out, it would seem to exposure the ECB to a debt write down as it would likely default. Currently ECB is not participating in the private sector haircuts.

There is an alternative scenario, which does address the underlying institutional challenge and that is a fiscal union led by Germany. Many of those advocating the ECB be the lender of last resort do not offer a quid pro quo. A fiscal union led by Germany would in effect force debtor nations who want more German and ECB support to surrender more of their fiscal sovereignty, in a binding way, to EU Commissioners, who would have greater authority in shaping national budgets and fiscal policies.

Rather than ECB bond buying or a common bond issuance being a solution to the problems, those activities are only possible one the solution is in place. Needless to say monetary union was a significant surrender of monetary sovereignty. However, by retaining fiscal sovereignty, countries found an escape hatch. A move to fiscal union is to close this loophole.

What elected leader can surrender such sovereignty? Maybe none, but that is why the unelected governments in Italy and Greece are interesting. The former, led by former EU Commissioner Monti, is particularly intriguing as he meets with Merkel and Sarkozy tomorrow (a meeting that might not have been held if Berlusconi was still in office), ahead of next week's EU summit.

German and French officials seem willing and eager to modify treaties and seek pursue closer integration. As the crisis unfolding, officials have consistently sacrificed ideological stances in the face of economic and political reality. This process is arguably more likely to continue than to be put in reverse.