With the debt ceiling debate behind us, now might be a good time to get back to the biggest problem currently facing the world economy: the eurozone. While the European debt crisis may have slipped off Americans' radar screens in the past weeks, its significance has not diminished.

The Greek economy is not recovering. In the first quarter of 2011, Greek output contracted by 5.5 percent and Greece’s current account deficit remains considerable. But other countries are in trouble, too. At its peak in the last fortnight, the spread between Italian and German bonds reached a record 393 basis points. Prime Minister Silvio Berlusconi seems to be in a state of denial, blaming the crisis on speculators and slow growth in the world’s big economies, even as he has no credible plan for bringing Italy's soaring borrowing costs under control. Worse yet, the contagion is spreading beyond the eurozone’s periphery, as regulators in the UK have recently asked British banks to disclose information about their exposures to Belgium's government debt.

Euro: A flawed idea from the start.

It is obvious to everyone, save the European political elites, that the European monetary union is a dysfunctional arrangement. But that was just as clear back in the late 1990s when the groundwork for the euro was being laid.

After 1992, the EU emerged as a large political unit that possessed the ability to redistribute resources between different interest groups. In the modern world, democratic politics, at the level of the nation-state, provide the most usual way of reconciling, however imperfectly, the conflicting claims for economic redistribution. European politicians chose to eschew that option in favor of a much less transparent and much less sound redistribution scheme in the form of the currency union.

Under the Euro, Greece, Portugal, Italy, Ireland, and Spain were able to borrow at much lower interest rates than those which they would be facing outside of the eurozone. As a result, they accumulated too much debt and embarked on spending programs that they could not otherwise afford. And as the recession set in, their economic fundamentals were too weak to sustain such leverage.

In Spain and Ireland, low borrowing costs led to a real estate bubble. In Greece and Portugal, they encouraged the growth of entitlement programs and grew government bureaucracies. Neither of those two developments proved sustainable without the continual inflow of further funds from abroad. Once the crisis hit, private debt in Ireland became a problem for the whole of the eurozone because the Irish government decided to bail out its banks – a decision that could not have been taken had there been no prospect of external budget support. In Greece and Portugal, governments are trying to reduce spending to sustainable levels—but to no avail, since they do so without the possibility of increasing their countries’ international competitiveness through currency depreciation.

What’s next?

From now on, events can unfold in three distinct ways. The first possibility is a simple continuation of the status quo. European politicians might try to keep open the financing spigots to the struggling members of the eurozone, in the hope that they will be able to address their structural problems through a combination of fiscal austerity and economic growth. However, with no economic recovery forthcoming, those countries will not be able to tackle their fiscal and external imbalances anytime soon. As a result, a wave of disorderly defaults is likely to occur at the periphery, accompanied by the exit of some members from the euro. The downside risks of this process are enormous, given that a full fledged banking crisis in Europe is likely to have a much bigger impact on the global economy than the fall of Lehman Brothers in 2008.

The second possibility is that the situation is seized upon by the European political elites to consolidate the power held by European authorities in Brussels. That would require transforming the phony transfer scheme, which currently exists as a part of the monetary union, into a fiscal union in which German taxpayers would subsidize Europe’s periphery directly and permanently. Indeed, such an arrangement is what many Brussels politicos openly strive for. When the first Greek bailout was adopted, Nicolas Sarkozy was quick to declare that European leaders “had decided to give the eurozone a veritable economic government.”

Fortunately, a central European government still remains a somewhat distant idea, and it would be a tough political sell in the core countries of the eurozone. However, as we have seen in the past, European integration proceeds stealthily and is very successful at sidelining the standard democratic political processes.

There is also a third option, however. European political elites can allow for a systematic fiscal and monetary devolution. In this scenario, no transfers between European countries take place at all. The club med countries restructure their debts in an orderly way and leave the Euro to regain their international competitiveness. The eurozone is reserved only for structurally similar countries of Western and Central Europe, falling roughly within the German economic space. The broader EU returns to its roots as a free trade zone, and does not attempt to directly tackle, by political means, conflicts over economic resources between various interest groups.

We should hope for this third option. After all, democratic politics at the level of the nation-state is our best bet for keeping conflicts between interest groups within reasonable bounds. Unfortunately, this scenario may be the least likely of the three – at least in the immediate future. European politicians have invested too heavily in the edifice of the EU. Moreover, there are those who have a vested interest in keeping the present EU-wide redistribution schemes running.

As a result, Europe’s future is largely unpredictable. However, knowing that an economic meltdown or a European superstate are the two most likely scenarios is hardly comforting.

Dalibor Rohac is the deputy director of Economic Studies at the Legatum Institute.

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