By Patrick Artus

The scenario that seemed unlikely only a few months ago, a break-up of the euro, is now increasingly being considered as a hypothesis with a probability far from zero. It is not certain that an agreement can be found between Greece and the European authorities and the IMF ― the austerity demanded from the Greeks, which is destroying the country’s economy, is now rejected by all political parties.

Helping Greece would require helping the country to reconstruct its economy, attract investors and create jobs, something the Europeans probably have no desire to do. This may lead to a breakdown of the negotiations, to the end of the loans to Greece, and therefore to a Greek default on all its debt and its expulsion from the euro or, technically, from the euro payment system between central banks.

What may happen with Greece may happen with other eurozone countries facing severe problems, especially Portugal and Spain. Spain is suffering from the consequences of a huge excess of debt, due to the fall in real estate prices. As in Japan in the early 1990s and in the United States with the subprime crisis, households and property developers in Spain have a debt that is not counterbalanced by the assets bought with the debt, since the price of these assets, mainly real estate, has declined. This excess indebtedness is massive, at more than one year of gross domestic product, and in the absence of European solidarity will lead to a very long period of zero growth and difficulties for borrowers, banks and public finances. At a certain stage, a country in this situation may be tempted to see a sharp devaluation, i.e. an exit from the euro, as the only way out.

How can the euro be saved if there are incentives for some countries to pull out, which would probably trigger the complete destruction of the currency?

We have to differentiate between two horizons, the short term and the long term. In the short term, it is crucial to prevent the financial crisis from degenerating and from becoming an acute, destructive one that would force borrowers to default and countries to pull out of the euro.

This will probably require driving down the excessive interest rates paid by some countries through another round of purchases by the European Central Bank ― a positive outcome of the crisis cannot be expected when Italian and Spanish long-term interest rates are between 6 and 7 percent and growth is sharply negative in these countries.

This also requires preventing a run on banks, like the one taking place in Greece, by very rapidly creating a European deposit guarantee fund and by recapitalising the troubled banks with European funds, as the Greek, Spanish and Portuguese governments do not have the means to recapitalize their countries’ banks.

Lastly, saving the euro in the short term also requires rapidly reducing the unsustainable debts of, respectively, the public sector in Greece and Ireland, and the private sector in Spain and the Netherlands through restructuring programs that make them bearable for the borrowers. There is no example in history of countries that have survived the total debt ratios, private and public, seen today in certain European countries.

Beyond these short-term emergency measures, one must think about the conditions and the long-term institutional reforms that can prevent a situation where some countries ultimately prefer paying the costs of pulling out of the euro rather than bearing the costs of maintaining the euro, such as sluggish growth and high unemployment.

The main problem in the long term is clearly the very significant heterogeneity of eurozone countries, with their very different productive specializations. In particular, this has led to the presence of countries that normally have structural external surpluses if they have a large-scale industrial sector and structural external deficits if their industry is small.

This is unsustainable with the current euro-zone institutions, in the absence of government transfer payments between countries that would offset the external deficits and prevent the accumulation of debt that inevitably leads to a financial crisis.

Therefore, the only long-term solution to keep the euro is federalism, in other words the implementation of government transfer payments between countries, from the rich countries with surpluses to the poor nations with deficits. Even though this development is not accepted today, it is essential.

Patrick Artus is the chief economist of French bank Natixis.