What is the most important problem for the eurozone? Clearly, the competitiveness and debt crises in southern Europe, both of which resulted from inflationary credit bubbles. Excessive capital imports ended up burdening the southern countries with unsustainable debt and making them too expensive. To solve their competitiveness crisis, they now need to deflate to lower their overblown prices, in some cases by 30 percent or more. However, that will drive many debtors into bankruptcy, cause unsustainable mass unemployment, and bring the unions to the barricades.

To cut the Gordian knot, Europe needs a debt conference to forgive some of the bank debt, the government debt, and the debt built up between the central banks (Target debt). Also needed is a program for orderly temporary exits from the currency union to realign exchange rates. Re-entry after the realignment and after structural reforms are completed should be envisaged.

Once these immediate measures are implemented, the rules of the Eurosystem as such need to be amended so as to discourage excessive capital flows and avoid the emergence of renewed bubbles in the future. First, new rules for state bankruptcies are necessary to clarify the procedure for the provision of debt relief. Second, the European Central Bank has to abstain from acting as a lender of last resort for regional (member-state) debt, following the rules of the U.S. Federal Reserve and the Swiss National Bank, which would never bail out states or cantons. Third, an internal gold standard for settling the inter-district imbalances between national central banks is necessary, such as the one that existed until 1975 in the United States, so as to make the ECB’s bail-out with the printing press less likely in the future. All these measures will make it convincingly clear to investors that bail-outs are not an option, prompting them to demand higher yields from states that borrow too much. The higher interest rates will in turn prevent excessive borrowing and the emergence of new inflationary credit bubbles.

In the long run, Europe could and should develop along the lines of the Swiss confederation, that is, creating a common state with a common government, parliament, and army. Only after that should it develop into a fiscal union, but hopefully never into a debt union, in order to avoid the terrible consequences that Alexander Hamilton’s debt mutualization program brought to the United States around the 1840s. At that time, twenty-nine states and territories went bankrupt because debt mutualization had encouraged them to borrow excessively. This added to the tensions that later drove the United States into a devastating civil war. It would be wise for Europe to learn from the U.S. experience.