Stephen King: Off with its head? The four 'impossible' solutions that face the eurozone

Economic Outlook: Countries attempting to bring back their own currencies would suffer excessive appreciation or complete collapse
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The Independent Online

Why, sometimes I've believed as many as six impossible things before breakfast." So said the Queen to Alice. The idea was weird, as was the Queen. Yet it is precisely the approach needed to understand what is happening in the eurozone. The sovereign crisis has still to be resolved. All of the solutions, however, seem in one way or another to be impossible.

The efforts so far to extinguish the fires of fiscal uncertainty have failed. First we were told that only Greece had a problem and that other fiscally challenged countries were committed to deficit reduction. Then we discovered that, despite their commitment to austerity, the Irish were forced to accept a huge increase in government debt thanks to a massive banking bailout. Portugal succumbed shortly afterwards, a consequence of ongoing economic stagnation. And now, after a brief respite, investors are worrying once more about Spain, fearing that the headline fiscal numbers may not be a true reflection of what lies beneath.

So what are the solutions? There are four. They are all impossible. One of them, however, will eventually have to become an unlikely reality.

The first option is the one that will prompt a torrent of smug "I told you so" comments from people in New York and London. The eurozone will simply break up. If countries are unable to agree on the fiscal rules of the game, they may eventually have to go their separate ways. How might a break-up happen? Either Germany, the eurozone's key creditor nation, walks away, not prepared to provide endless blank cheques to the peripheral nations. Or, instead, Greece walks away, unwilling to put up with the endless demands for austerity foisted upon the Greek people by its richer European partners.

This would be a catastrophe for the European Union. The collapse of the euro would reveal a deep-rooted lack of political will, threatening the survival of a political arrangement that has not only successfully kept the peace for many decades but which has also offered a democratic blueprint for nations in central and eastern Europe formerly under communist rule.

Even though eurosceptics in the UK might cheer, it's difficult to imagine nations elsewhere in Europe thinking that the demise of the euro would bring anything other than bad news. In economic terms alone, it's hard to contemplate the scale of the damage. Countries attempting to re-introduce their own currencies would either suffer excessive appreciation (Germany) or complete collapse (Greece), creating a further wave of financial anarchy. And with anarchy comes the threat of political extremism. The first option is, therefore, impossible.

My second option is a unilateral default by one or other of the peripheral nations, without any concern for the creditors. It's an unlikely choice in the near term. Greece, for example, still has to borrow to fund current expenditure so any decision not to pay its creditors would force Athens to deliver immediate and draconian tax increases or spending cuts. Imagine, however, that the Greeks sufficiently improve their fiscal position in the years ahead to enable them to close the gap between revenue and domestic spending. At that point, they would only be borrowing to pay interest to their - mostly foreign - creditors, making a default a lot more tempting. Investors are well aware of this risk, one reason why, despite all of the efforts to deliver austerity, the interest rate on Greek government debt remains so painfully high.

This, though, is also impossible. In the event of a unilateral default, Europe's politicians would again have botched. They would have failed to address the balance of interests between the creditor and debtor nations. That failure, in turn, would reveal fault lines at the heart of the European project, leaving the future of the euro incredibly uncertain. Contagion would threaten to bring the single currency to an unsavoury end.

The third option is to carry on "muddling through", hoping that, eventually, the markets will forgive the peripheral nations and allow them to borrow on more favourable terms. It's difficult to see quite how this is going to happen. The more austerity these countries have delivered and the more their economies have weakened, the more their interest rates have risen. The market is in no mood to forgive. Instead, it scents blood.

The implication is clear. If the peripheral nations have to borrow but cannot afford to borrow from the market, they will instead have to borrow from their European partners at heavily subsidised interest rates. And if this carries on, it won't be long before the countries of the eurozone will have inadvertently created a fiscal transfer union. These just about work within nations - money pours into southern Italy from northern Italy and from Munich into Bremen - but it's a lot more challenging to pull off the trick between nations. Would German taxpayers really be happy to be supporting Greece for ever more without any influence over how their hard earned cash was being spent? Again, this seems impossible.

My fourth - and final - option is a choreographed restructuring which establishes a clear principle, namely that the crisis is as much the fault of the creditors - who lent too much at stupidly low interest rates - as it is the fault of the debtors - who borrowed too much and invested the money in silly property booms. This choreographed restructuring might be described as a "burden-sharing" arrangement, designed to ensure that everyone pays some of the bill but no one pays all of it.

This would differ from the creation of a fiscal transfer union in two distinct ways. It would allow a reduction in the debt burden in the periphery, rather than making them forever dependent on the deep pockets of the creditors. And, rather than taxpayers alone in the creditor nations taking the hit, a restructuring would also imply losses for the shareholders and bondholders - either the financial institutions themselves or their owners, creditors and customers.

And this is also impossible. A restructuring of this kind might lead to a breakdown of trust within the financial sector sufficient to trigger a Lehman-style meltdown. In the process, the economic woes now engulfing the peripheral nations would spread all over Europe and far beyond.

So, if you're about to have breakfast - and you're following the philosophy of Lewis Carroll's Queen - you might reflect on which of my impossible options will eventually turn into reality.

For what it's worth, I suspect countries will eventually end up opting for choreographed restructuring. But to do so, they'd have to work especially hard to avoid a Lehman-style meltdown. That would require the European Central Bank to be willing to buy assets without limit to keep the financial cogs turning.

And, to appease the creditor nations, it would also require a shift towards a fiscal "act of union", designed to prevent equivalent fiscal accidents from happening in the future.

None of this seems particularly plausible. The political will seems to be largely absent - one reason why the crisis is not being resolved right now. Given the impossibility of the other options, however, knowing that a choreographed restructuring is impossible doesn't entirely rule it out.

Stephen King's book Losing Control: The Emerging Threats to Western Prosperity (Yale University Press) is out in paperback