The Worst-Case Euro Scenario

Each day the currency remains on life-support in its current form, the consequences of its eventual death become graver.

The Wall Street Journal

By SAJID JAVID

On the Continent, August is usually reserved for long vacations in the sun. Instead, European leaders spent the month working on increasingly desperate attempts to save the euro in its current form. There's only one prospect more frightening than what would happen if they fail: what would happen if they succeed.

This is not hyperbole. The euro is an idea built on economic and political dishonesty, at the heart of which lies a flaw that the currency's architects never dared to address: Given that the euro zone's economies are so different, how could a single interest rate possibly apply to all of them? And how could these countries, having surrendered monetary policy, continue to control national public spending and therefore the size of their deficits and debts?

These points might have been moot if the monetary union had also been a fiscal union from its inception. This would have required that the euro system include a framework of tax transfers, such as America's or Australia's, whereby the federal government redistributes funds to weaker states from stronger ones.

The alternative, of imposing collective fiscal discipline in a currency union of sovereign states, each answerable to its own electorate, could only have been achieved by subordinating the will of democratically elected politicians and their voters. Until now, even EU mandarins have been unwilling to go this far. That's why the fiscal rules stipulated by the euro's founding Stability and Growth Pact were destined from the start to be ignored: To do otherwise would have been blatantly anti-democratic.

Europe's politicians nevertheless thought they could have it both ways: a single currency among divergent economies, each with fiscal autonomy, allowing them all to borrow and spend to their hearts' content. No surprise then that the euro has turned into a bankruptcy machine. Once the markets had finished with Greece, Ireland and Portugal, they were bound to move on to Spain, Italy and—soon—France. The proximate causes for each of these crises may be different (excessive sovereign debt, over-leveraged banking sectors, property-market bubbles) but the root is exactly the same: the euro.

Adopting the euro has allowed these economies to mask their underlying lack of competitiveness and borrow on the strength of other countries' creditworthiness. It's not a problem of liquidity, as the euro's apologists would have you believe, but of solvency.

The currency's troubles, however, go even deeper than bad economics. Politically, there is no hope that a fiscal union would save the euro. Let's be clear what that would mean: a single treasury, tax regime, welfare system and public-borrowing function. This option would fail for the exact reasons that European leaders avoided it from the outset: It would be massively undemocratic, relegating national politicians and voters to the role of helpless bystanders. Why would the Greeks willingly become a German vassal state? Why would German taxpayers willingly subsidize a bloated, inefficient, Greek public sector?

Given the arrogance that many European leaders have shown to date though, I fully anticipate a rapid move towards fiscal union. It won't come about through cozy formal chats, such as last month's Merkel-Sarkozy meeting, but as a response to a severe market crisis. The next one could come as soon as this month, when Italy is due to raise or refinance more than €68 billion of its public debt.

Back-door fiscal union is already underway. Now that the European Central Bank has started buying Italian and Spanish government bonds, expect the ECB to issue its own bonds to fund this. All of this, as German President Christian Wulff said last month, without the mandate or legitimacy of treaty changes or popular support.

As for Britain, there is little it could do to protect itself from the economic fallout of a collapsed euro. We must be grateful, however, that europhiles in all three major U.K. political parties did not get their way. Britain could well have been in the same situation as Italy and Spain, were it not for its ability to depreciate sterling and set its own interest rates. And at least the U.K. now has a government that recognizes the need to tackle its own national debt.

Whenever the inevitable overhaul of euro-zone arrangements begins, Britain must then renegotiate its EU membership. In 1975, the British people voted to join a Common Market for goods and services. Perhaps now that can finally be achieved.

Each day the euro remains on life-support in its current form, the consequences of its eventual death become graver. If European leaders would only accept that their grand economic experiment has failed, the impact would be more predictable and more manageable. There would still be bank failures and heavy losses but, by acting decisively now, there is still an opportunity to avert catastrophe.

Mr. Javid is a Conservative member of the British parliament and a former Deutsche Bank executive.