There is only one way to save the Euro now. The ECB acts as lender of last resort to the 17 Eurozone governments. But nobody would want to act as lender of last resort to a deadbeat, and the ECB wouldn't want to act as lender of last resort to a fiscal deadbeat. With the guarantee of unlimited loans from the ECB, the fiscal deadbeat would have every incentive to keep on borrowing and spending unlimited amounts. It's a mix of: the free-rider problem (because they are only one in 17, and even less than that for a small country); and the Samaritan's dilemma (if they know you are going to help them get out of trouble, they are not going to stay out of trouble).
The Eurozone lacks a central fiscal authority to match the central monetary authority. And it seems to lack the ability to create a central fiscal authority in the normal way. Nobody seems to have the power to exert that central fiscal authority, and force the 17 governments to do what they are told.
But the ECB does have that power. It can say to each of the 17 governments: "We will act as your lender of last resort if and only if you do what we say. If you don't do what we say, we will loudly announce that we will no longer act as your lender of last resort, and the bond markets will make mincemeat of your bonds, and there will be runs on all your banks."
In fact, the ECB is the only body that does have that power. I'm not talking about legal power. It's long past that stage of the game. Good central banks ignore all the rules in an emergency (as Brad DeLong tells us the Bank of England did for a century). The ECB has the de facto power to save any or all of the 17 countries. But it won't use that power unconditionally. It has to make the 17 governments do what it tells them to do. It has the power to do that. "Do what we say, or your country is toast".
The normal question in political macroeconomy is whether the monetary authority should have independence from the fiscal authority. It's time, in the Eurozone, to reverse that question. Should the 17 fiscal authorities have independence from the one monetary authority?
Is this democratic? Of course not. Might it happen? I don't know.
Update: edeast in comments directs us to this very relevant piece by Jacob Funk Kirkegaard of the Peterson Institute for international Economics.
Worthwhile Canadian Initiative 
“Good central banks ignore all the rules in an emergency (as Brad DeLong tells us the Bank of England did for a century).”
That reminds me of a good quote:
“All Central Bank Governors like quiet lives, working behind the scenes and in the comfort of their tall buildings and plush offices, and only appearing in public once or twice a year.
“But the question to answer is ‘Are we in a normal situation demanding normal policies and practices in Zimbabwe today?’ Let’s pause and stop the blame game regarding who is responsible for our situation and simply say whatever the cause, are we in a normal environment today?
“Certainly not… Thus in the economic sphere, we are living in extra-ordinary times and as such, only extraordinary monetary policy and fiscal policy initiatives are needed to secure our survival as an economy let alone growth… These interventions are never meant to be permanent features of our economic lives but today, they are necessary just as some extra-ordinary measures were necessary for the survival of the economy during UDI days [when Zimbabwe was fighting for independence].”
Anyways, that was Gideon Gono’s paen to breaking the rules of the RBZ Act in an emergency. Two years later the Zimbabwe dollar had ceased to exist.
“But the ECB does have that power. It can say to each of the 17 governments: “We will act as your lender of last resort if and only if you do what we say. If you don’t do what we say, we will loudly announce that we will no longer act as your lender of last resort, and the bond markets will make mincemeat of your bonds, and there will be runs on all your banks.””
I can’t see why this wouldn’t work in theory, it’s how a private clearinghouse regulates its member banks. However, I’d be skeptical about the credibility of any no bail-out threat emanating from a European institution since the Eurosystem’s initial no-bailout clause was dashed last year. Fool me once, shame on you, fool me twice…
Nick, I agree that various Eurozone countries used the low cost of borrowing to run up debt (as did the US, of course), but I also take the point of David Glasner and others that tight money policy by the ECB when a serious negative economic shock was sweeping through the global economy made things worse (as did the Fed, of course). Greece (and California) would have likely been in trouble anyway, but the other countries, not so much.
Tino Sanandaji provides evidence that joining the Euro cruelled Italy. Joining the Euro fundamentally changed the rules of political economy for the Mediterranean economies but it was seen as “hard currency” and “cheap borrowing”: all upside, no consequences; no changes to the rules of the game.
Lorenzo, your point on the American Civil War is a straw man.
My point is that the Central Bank tail wagging the Ministry of Finance dog is just not going to happen. You can’t subvert democracy and responsible government that way. Not event the ECB can do that.
There is a way to do things but this is not it.
“It’s time, in the Eurozone, to reverse that question. Should the 17 fiscal authorities have independence from the one monetary authority?”
Any of the 17 fiscal authorities can literally show a middle finger to ECB and then ECB can evaporate into the void overnight. There is no central bank without fiscal authority and if even one chair falls out the whole house can collapse under fire.
This is what the first Papa tried to do bu failed. Well, somebody one day will get it right.
Lorenzo From Oz,
In an important sense, the Eastern Bloc countries weren’t socialist. Hayek and Mises were right: they COULDN’T be socialists, in the old sense, even though they wanted to be so.
I suppose the parallel is with euro membership criteria: whatever their merits or flaws, Greeced proved that they don’t exist, and they won’t be enforced because the euro is a primarily political, rather than purely economic, project.
Determinant. You mean red herring: a straw man would be if I misrepresented your argument. My point was that political solutions are not always viable–disaster can happen.
You seem to be wavering back and forth between “that’s outrageous!” and “it won’t happen!”. Plenty of outrageous things happen, so they are not the same claim. And the French President and German Chancellor effective organising to bring down uncooperative Mediterranean PM’s doesn’t seem all that hot from the democratic legitimacy perspective–but that seems to be what has been happening.
If the ECB cannot bring fiscal policy into line and, as W.Peden points out, the fiscal authorities are failing to bind themselves effectively, then the downhill spiral will continue. Then we are at my point about the antebellum US countdown to disaster and political solutions which are not viable.
One wonders if the ECB is not already playing a game of fiscal-monetary “chicken”: until those fiscal policies are acceptable to us, we will continue our tight money policies.
Citing Australian experience again, the fact that fiscal policy has assiduously sought to give as much scope as possible for the Reserve Bank to stabilise the economy is not a small factor in Australia’s continuing macroeconomic stability. But we have one federal fiscal authority, one monetary authority and they talk to each other: both privately and publicly. And that monetary policy is explicitly agreed between that one fiscal and one monetary authority allows for a very clear game to be played, one where the “democratic” fiscal policy clearly has one eye very firmly on likely responses by the “independent” central bank.
With a 17:1 arrangement, only very explicit rules could possibly have made the thing work, and it has been demonstrated that none of those 17 fiscal authorities will keep to the set rules. So, either the system acquires an enforcer or it will collapse. If the ECB is not the enforcer, and the fiscal authorities are demonstrably failing to fulfill the role, the next stage is collapse.