The problem with Europe is that everyone there has one and a half monetary systems. You can have one, two, or fifty, but you can’t go halfway.
Every country has the “one” monetary system that constitutes explicit use of the Euro and implicit use of Germany and France as collateral. But each country also has about half of another monetary system: the implicit one they develop when investors analyze their debts with a Euro dissolution in mind. It doesn’t have to be this way, and it doesn’t have to end with a split: why not create a system where the Euro works by the Euro’s rules, and everyone brings back their home currencies to finance their financial misdeads?
Here’s how it would work: as long as a country is running deficits within EU deficit limits, it can issue debt denominated in Euros. That’s supposed to be the status quo now. The problem is not just that there isn’t an enforcement mechanism (nobody ever got kicked out of a monetary union for being over one limit by .1%). The real problem is that there’s no close alternative: you borrow, or you lose an election to someone who will.
So, instead of letting people borrow in Euros past the point where their borrowing destabilizes the Euro, reintroduce their home currency *mostly* as a vehicle for extra borrowing. France can borrow up to 3% of their GDP per year in Euros, but anything beyond that must be borrowed in Francs.
What does it mean to borrow something in Francs? Whatever France says it means (just like any other fiat currency). Just to keep things simple, and to provide a way to extinguish the currency in case they stop running such egregious deficits, each country could agree to let large taxpayers pay their taxes in either Euros or the native currency. This lets each country pick an exchange rate, and build their own monetary policy, without giving up on the Euro. If you’re confident that Italy will turn itself around, lend to them in Lira—you’ll get a healthy interest rate, and you can cash in some bonds each year to pay your taxes. Worried they’re printing too many Lira? Buy their Eurobonds instead; by turning EU dissolution into a stroll down a hillside rather than a jump off a cliff, this system reduces sovereign credit risk, too.
Would countries have an incentive to screw over their Euro-lenders to help native borrowers? Maybe, but it’ll take at least a generation to have as much non-Euro debt as Euro-debt outstanding. And since local buyers already buy plenty of Euro debt, that means it’ll be years before it’s possible to help out local bondholders without hurting them, too.
And this lays some very interesting infrastructure. Once these currencies start circulating among large, institutional investors, it’s only a matter of time before they start trickling down into traditional businesses. Lots of German companies will be relieved that they can pile up Deutchmarks instead of Euros again. And that will lead to a very interesting situation, indeed: a currency with a readily ascertainable value, a fairly liquid market—and no physical currency. One can imagine German banks offering customers the option to use their debit cards for Deutchmark-denominated savings accounts (instantly convert to Euros and spend! And, after a while, don’t bother converting to Euros, because merchants will be happy to take Deutschmarks, too).
Through steady adverse selection, you’d see the Euro turn into a specialized currency: something you use to pay your taxes, or to settle deals struck before the new currency became available.
At that point, Europe’s financial leaders will be at a cross roads: there will be a clearer path to dissolving the Euro, which also means it’s a more realistic threat; they won’t be able to assume that nobody would break the rules. At that point, you can imagine two selection effects: either the most responsible countries leave the Euro one by one, or the most tenuously Euro-y countries cut their deficits one by one. Either way, this will lead to the kind of fiscal harmonization the Euro relies on.
Or it won’t, and we’ll be back to the old monetary paradigm. Which, in retrospect, wasn’t as bad as we thought.