Derek Thompson - Derek Thompson is a senior editor at The Atlantic, where he oversees business coverage for the website. More
The euro arrangement either worked out horribly, or a little too well, depending on how you choose to look at it. Investors lent lots of money to peripheral economies, which led to large capital flows from the core to the periphery, and corresponding trade deficits, or "current account imbalances."
As Paul Krugman (who shared this graph) explained, these capital inflows caused a boom in the periphery that raised costs and prices dramatically. Once again, this was somewhat the point. When a country gets richer, costs and prices should go up.
But now the tide is out, and the PIIGS's finances have been revealed as unsustainable. The simplest solution would be to break up the EU and let Greece and other troubled countries go back to their own currencies, devalue like crazy, and trade their way to growth. But the market likes certainty, and you can't very well blow up a ten-year experiment in economic unity without inviting a financial crisis. So we've reached the point of no good choices.
The standard line is that there are two paths for Europe from here on out. Come together or fall apart. Fiscal union or financial catastrophe.
Analysis thrives in black and white, but the reality is much more gray. Fiscal union might persuade investors of Europe's long-term seriousness. But austerity will shrink the peripheral economies, which will make the road to primary surplus even harder. Higher inflation could raise overall demand, but a cheaper euro won't help Greece and Italy experience a full export recovery because most of the PIIGS' trade is within Europe.
It's much more likely that the next few weeks and months will be just as messy and confusing as the last 18 months. Greece is beyond saving. It might be months from default. Italy and Spain, on the other hand, might be salvageable with lower interest rates. That suggests the ECB should step up and act more like the Federal Reserve by backstopping Spanish and Italian debt. With more affordable borrowing costs, the euro should survive 2011.
"But fiscal unity only matters if countries get rid of their budget deficit," Lachman explained, "because you can't control deficits if everybody cuts at the same time."
"You've got countries moving into a recession and real credit crunch, with Greece moving toward disorderly default," he said. "I can see how the can gets kicked down the road and the crisis gets slowed, but I don't see the endgame."
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