Curious Capitalist

Europe’s Economic Woes: That Sound You Hear Is the Euro Cracking

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A breakup in the euro zone just got more real with the announcement of the short list for the Wolfson Economics Prize, a prestigious economics award that has the biggest payout (£250,000, or about $400,000) after the Nobel Prize. This year’s Wolfson-challenge question was: “If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?” The fact that we now have several published answers to that question written by serious economists makes the breakup issue all the more pressing.

The basic problem hasn’t changed since I first wrote about it in TIME’s cover story “The End of Europe” last summer. The euro zone has always been a selfish union, crafted in times of unprecedented growth that are unlikely to be repeated and predicated on short-term economic gain rather than longer-term political union within Europe. To fix the euro, you have to fix that problem — and as we’ve written many times, it’s tough to do without a common fiscal union, as you have in the U.S., in which money can be transferred from stronger states to weaker ones.

(MORE: Is Germany’s Euro-Crisis Strategy Actually Working?)

The latest Band-Aid put on the euro-zone troubles by the European Central Bank (ECB), in the form of a $1.2 trillion loan to European banks, isn’t working, at least not to solve the core problem. The euro-zone economy has now contracted for a second consecutive quarter, and labor markets and lending are deteriorating. A double-dip recession in Europe is pretty much baked in.

The good news is that the ECB’s cash infusion has probably staved off, at least for the next year or so, a full-on European banking crisis, which would almost certainly infect the U.S. The bad news is that come May, when Greek elections are held and a new government has to approve the latest austerity deal, the euro is likely to start unraveling.

(MORE: Why the Latest Euro-Zone Debt-Crisis Agreement Shows How Europe Just Doesn’t Get It)

Which is where the Wolfson ideas come in. I think the very bright guys over at Capital Economics in London have sketched out one of the likeliest scenarios, which is that Greece decides to leave the euro zone, go back to the drachma and default on a large part of its debt. Bad news, but still possible to manage without a global meltdown. So the drachma falls by 50% — yes, there would be chaos in the Greek, and possibly the European, financial system for a time, but Greece would quickly reap the competitive benefits of having a much weaker currency.

The rub is that if the Greek default went reasonably well, a bunch of other countries, like Spain and Portugal, may want to opt to default too. In order to avoid that, say the guys at Capital, the rest of the euro zone is going to need to move very quickly toward a full fiscal and political union. But, as I wrote last summer, there wasn’t enough political will to get all the countries to sign on to such a union in the first place — and that remains just as true today. Perhaps the next Wolfson challenge should be, “How can every country in Europe become more like Germany?” The prize would be a eurobond.

MORE: In Emotional Economics, How We Feel Can Predict How We Deal with the Markets

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