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Pedestrians walk past pre-election posters in Athens on June 13, 2012. Greece holds general parliamentary elections on June 17.


Here is the biggest question about the euro zone: can we envisage a set of reforms that are not only politically feasible and economically workable, but would let it prosper, as it is. If so, what might they be?

We already know that, as designed, the euro zone did not meet this test. Hence all the improvisation of today. The original design created huge imbalances. When the flow of finance dried up, these delivered a wave of financial and fiscal crises and a legacy of unaffordable debt. Furthermore, the forces driving those imbalances generated divergences in competitiveness. These also need to be redressed, as quickly as possible.

In response, the euro zone has developed a strategy based on fiscal austerity and structural reform. In addition, the European System of Central Banks, as lender of last resort, and the International Monetary Fund and euro zone governments, via the temporary European Financial Stability Fund and, soon, the permanent European Stability Mechanism provide indirect financing for fragile economies and sovereigns. The $100-billion proposed rescue of Spanish banks is the latest example of this strategy at work. It is unlikely to be the last.

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Will the strategy work? Probably not. As Mark Cliffe and his team at ING note, in a report entitled Roads to Survival, a good way to think about the challenge is in terms of the external and internal imbalances bequeathed by the incontinent cross-border lending prior to the crisis.

If external deficits are to be reduced, domestic demand must shrink. If done too swiftly, this would raise unemployment, possibly enormously. In the long run, high unemployment, aided by market-oriented reforms, should drive down nominal wages. But this could take many years. Meanwhile, persistently weak economies mean a growing mountain of bad private debt, high fiscal deficits, rising public debt, high interest rates and extremely fragile financial systems.

This strategy, then, looks neither politically feasible nor economically workable. Now consider alternatives. A federal union, with a federal government that finances spending throughout the union, is certainly economically workable. We have many examples: the United States, Canada, Australia, Switzerland. But we can safely say that, whatever the position may be a century from now, the euro zone is very far from able to share such a government.

A less ambitious -- but still ambitious -- alternative would be a transfer union, by which I mean a system of permanent transfers from richer to poorer member countries, as is normal within countries. This is surely politically infeasible. Above all, it is neither necessary nor desirable from the economic point of view. It is unnecessary for poorer countries to run sustained current account deficits, provided wages remain in line with productivity (as ceased to be the case for several members during the pre-crisis boom). It is undesirable for countries to receive large and sustained net transfers, because that tends to entrench backwardness.

If the current policies seem unlikely to work and either a federal or a transfer union is ruled out on grounds of political or economic infeasibility, what is left? I suggest the combination of two ideas: "insurance union" and "adjustment union". By an insurance union, I mean one that provides temporary and targeted support for countries hit by big shocks. By an adjustment union, I mean one that ensures symmetrical adjustment to changes in circumstances, including, changes in financing. Both are necessary and, together, they should be sufficient to ensure a workable union in the long run. These notions would have been unnecessary if original members had been far more similar: the minimal union would then have worked. But that is not what now exists. If the euro zone is to sustain its current membership, it needs a combination of insurance and adjustment.

Before the birth of the euro, some economists thought that members might use fiscal policy to cushion country-specific shocks. We now know this does not work, even if (as was true for Ireland and Spain), the victim began with a healthy public finances. Really large capital inflows and asset price bubbles overwhelm fiscal policy. For this reason, members cannot self-insure against severe shocks. Insurance must be provided collectively, on the principle that everybody benefits from the survival of the union. The insurance must support the financial system and (if possible) fiscal solvency in a crisis. But if it is to be insurance, not an open-ended hand-out, conditions must be imposed. Designing insurance that stabilizes financial systems and sovereign finances in a crisis is tricky, but not impossible. Clearly, support needs to be larger and more automatic than now, without being open-ended.

More important even than such insurance is adjustment. Members need a chance of returning to health within a reasonable time period provided they adopt sensible policies. If members -- particularly large members -- are to adjust, they will need complementary adjustments elsewhere. More precisely, the necessary return to external and internal balance in crisis-hit countries cannot be achieved without higher spending and inflation in the core. The European Central Bank is astonishingly complacent in failing to react to yet another recession.

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Unless one imagines that the world economy could now cope with a big shift by the euro zone as a whole towards surplus, the rebalancing must occur largely inside the euro zone. If this adjustment is blocked by weak demand and very low inflation in core countries, the vulnerable countries will be locked into semi-permanent slumps. That way lies close to guaranteed failure.

Is it possible for the euro zone to make the needed reforms in the near future? I do not know. The time may now be too short and the irritation too great. But, conceptually, it seems clear what is needed: a swift and effective move towards an insurance and adjustment union. That is neither a federal union nor a transfer union. It is a way of making it possible for countries that remain largely sovereign to share a single currency. I do not know whether even this is economically and politically feasible. But if not that, what? And if not now, when?

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