The recent Brexit vote has Euro-skeptics crowing that the EU and Euro are in their death throws. I will be the first to acknowledge that the Euro has served many members of the currency bloc poorly, particularly Spain and Italy. The essence of the European crisis is a balance of payments crisis, not a debt crisis. Large structural trade imbalances developed within Eurozone, with the most productive nations like Germany and the Netherlands running huge current account surpluses. This meant that deficit countries like Spain and Greece were placed in an untenable position. Under a floating exchange rate regime, the Spanish Peseta and Greek Drachma would have depreciated against the Deutsche Mark, raising the cost of German goods in these countries and helping to bring the balance of payments back to a healthy equilibrium. With the fixed exchange rate of the Euro however, these countries faced two bad choices. They could:
1) Borrow from a abroad to finance the current account deficit. In the boom years of the 2000s, this is basically what most countries did.
2) Engage in fiscal austerity to deflate their economies to achieve the real devaluation sufficient enough to balance the current account. This has been going on since about 2010 with disastrous results. It's an idea that works in theory, but in practice prices can't fall fast enough.
Of course, Spain and Greece and other poorer Eurozone nations could implement "structural reforms" to try to boost their productivity and make them competitive with Germany and the rest of Northern Europe. However, these initiatives, such as investments in education, take decades to bear fruit and aren't much for solving an immediate crisis.
Also, the richer European nations like Germany could engage in fiscal transfers to help the Greeks and Spaniards finance their current account deficits, much like California subsidizes Mississippi in the United States. However, after six long years, and the vote last Thursday, it is clear that Europe is far away from becoming a federal state. Thus, a radical solution must be implemented.
The Eurozone should contract to include only five or six core members, most likely Germany, France, the Netherlands, Belgium, Luxembourg, and Austria. Automatic fiscal transfers between nations in the would be triggered if current account imbalances between countries occurred. This would prevent balance of payment crises from developing and would make sure that no nation would be put in the unenviable position of having to borrow heavily or implement deflationary policies. While it is true that fiscal transfers have so far proved politically untenable, a smaller bloc of nations which share borders would have a much easier time hammering out the details of such an arrangement than the current 19 member Eurozone. The six nations I have proposed also have similar levels of productivity and thus any fiscal transfers would be small. Greece or Spain however, or even Italy, would probably require much larger fiscal transfers to remain viable, and that would most likely sink any negotiations.
The currency bloc would have supranational deposit insurance backstopped explicitly by the European Central Bank. This would prevent the kind of bank runs we saw in Greece and other crisis countries as people began to doubt the credibility of national deposit insurance. Because national governments have abdicated the power to print money, the EBC is the only entity which can make an iron clad, unquestionable promise to guarantee Euro-denominated bank deposits by virtue of being the sole issuer of the Euro.
The Eurozone is a victim of its own ambitions. It was designed without fiscal transfers or any mechanism to solve balance of payment issues, but it can't work without them. The Eurozone must therefore narrow its scope and size to serve those nations it can serve best. Failure to act will see the disorderly withdrawal of several of the weaker members, which will no doubt roil financial markets may result in a complete collapse of the Eurozone.
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