Any solution to the euro crisis must meet two objectives. One is short run and the other is long run. Unfortunately they tend to conflict.
The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising. Austerity won’t restore debt sustainability. It has raised debt/GDP ratios, not lowered them. A write-down would do it. New bigger bail-outs might too, or might not. But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.
By now just about everybody agrees that the European bailout of Greece has failed: The debt will have to be restructured. As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.
There is plenty of blame to go around. But three big mistakes can be attributed to the European leadership. This includes the European Central Bank – surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.