MUNICH — The euro-zone countries have now agreed to provide some 80 billion euro in cheap loans to Greece over the next three years, and hope that the International Monetary Fund will provide another 15 billion euro at the least. But the interest rate that Greece must pay buyers of its government bonds has shot up to a record-high level of nearly 9 percent — 5.9 percentage points above the benchmark rate paid by Germany. That translates into an additional 16 billion euro per year in interest payments on Greece's current debt of 273 billion euro. Obviously, markets still believe that Greece will default on its debt.

Greece, moreover, has another huge problem: Its current-account deficit is currently a whopping 13 percent of net national income, which means that 27 billion euro have to be financed annually by borrowing or selling Greek assets. With international investors no longer willing to finance this deficit, and even shying away from refinancing existing Greek debt, only three possibilities remain.

The first is that the EU provides the necessary funds on a permanent basis, creating a "European Transfer Union" to the benefit of the deficit countries, including Portugal, Spain, Ireland and Italy. The second option is for Greece to go through a depression, reducing its wages and prices. Finally, Greece could leave the euro and devalue its currency.

All three of these options are painful, albeit for different reasons. The first is unbearable for the more stable EU countries, because it would deprive them of their wealth and suck them into a dangerous fiscal maelstrom. The second would lead to even more riots in the streets of Greece, with unforeseeable political consequences. And the third would destabilize the euro, possibly resulting in a run on some other EU countries. As all the possible options are bad, the situation qualifies as a veritable Greek tragedy such as those hitherto seen only on stage.

Politicians believe that imposing more budget discipline on Greece is a fourth possibility. But this is not true. Budget discipline will work only insofar as it drives the country into a depression and induces a real devaluation through a reduction in wages and prices, which is option two. While that would stimulate inward tourism and real-estate sales, what sounds easy and manageable to the layman would in fact be the most problematic solution for Greece, because it would add fuel to internal protests to a point that could destabilize the eastern Mediterranean.

The tragedy could have been avoided if Greece had shown unyielding, timely debt discipline. The country would then have been unable to price itself out of the market through an artificial debt-financed boom. There would have been no high, but also no hangover.

The lesson to be learned from the crisis is that a currency union needs ironclad budget discipline to avert a boom-and- bust cycle in the first place. Again, there are three possibilities worth considering: * The American system. In the United States, there is no bailout mechanism and no intergovernmental loans. Profligate states go bankrupt if necessary. Markets encourage the required debt discipline in a timelier manner by charging higher interest rates on government debt. This system has worked quite well since the 19th century, even though (or because) it involved a substantial number of state bankruptcies. Given the perilous state of California's finances, it may well be tested soon. * The German system. In Germany, a "stability council" must approve state budgets. According to the German Constitution, the German states will not be permitted any budget deficit after 2020, and must already pursue fiscal consolidation in order to meet that goal. In exceptional cases, a state may run a deficit, but its cumulative volume must not exceed 1.5 percent of GDP. If it exceeds 1 percent of GDP, the excess is subtracted from the budget allowed for the following year, provided that the economy is in an upswing with a shrinking output gap. * A new EU system, following the logic of the bailout strategy that the EU is currently applying, should be extended to include automatic fines for "debt sinners." Loans would be provided by other EU countries if necessary, taking the form of covered state bonds collateralized with privatizable state assets. Their accumulated sum would be limited to 10 percent of GDP. Should a country default despite these loans, it would have to leave the euro and devalue.

Automatic fines would punish any country whose debt-to-GDP ratio exceeds the Maastricht Treaty's 60 percent cap or whose budget deficit exceeds the 3 percent-of-GDP limit. The fines could be as high as the interest premium would be in the absence of help, thereby ensuring that the benefit of enhanced stability under the euro accrues to all euro-zone countries, rather than to the profligate members themselves. In order to prevent sinners from getting caught in a debt trap, the fines could take the form of covered bonds collateralized with privatizable state assets.

All of this is unpleasant, and it may not appeal to politicians who believe in dreams. But the European debt crisis will not disappear into thin air by virtue of wishful thinking. It is time for Europe to face its true options in order to maintain the euro's stability — and that of the EU itself. Hans-Werner Sinn is a professor of economics and public finance at the University of Munich and is president of the Ifo Institute.

© 2010 Project Syndicate, www.project-syndicate.org

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