Is the curtain falling on the eurozone?

Milton Friedman, never a fan of the eurozone, predicted it would collapse in 10 years. Now entering its 13th year, the currency union is facing its most critical challenge. And at the Nobel -winning economist may turn out to be right on everything except the exact timing of the dissolution.

The reason? European leaders continue to miss the mark in their assessment of the root cause of the continuing crisis. To paraphrase Bill Clinton: It's the debt, stupid.

Earlier this month, European lawmakers held the latest in a string of emergency summit meetings to deal with the worsening crisis. Many billed it as the last chance to save the euro. If this is the standard by which the outcome is to be measured, the meeting was an abject failure.

The plan of action European officials positioned as the salvation of the euro consisted of an agreement to draft a revised treaty giving central European Union authorities greater control over how sovereign nations manage their budgets. The participants also agreed that EU central banks would lend another €200 billion ($262 billion) to the International Monetary Fund. This money would then be used by the IMF as part of the European Stability Mechanism to support the handful of countries struggling to remain solvent.

The first measure is unlikely to ever be ratified as an EU treaty in the face of British opposition. And the alternative fiscal compact that the other EU members are now trying to create is proving legally tricky, even before it runs a gauntlet of political challenges. This leaves the €200 billion loan to the IMF as the only probable legacy of the summit meeting. Unfortunately, it's not enough to address the issue.

Greece illustrates the problem.  As the poster child for eurozone fiscal incompetence, it owes all by itself roughly €350 billion in sovereign debt with about €200 billion of this owed to banks and other financial institutions. (The remainder is held by the International Monetary Fund and other countries.) But only €130 billion has been committed to helping Greece. Even if all €200 billion were committed to Greece alone, it would not cover the debt it owes. No matter how one slices it, that nation is headed for a partial default and the future remains very much in question.

Until the debt is addressed, the EU is simply throwing good money after bad. The reason is that even if EU leaders seem unaware of the debt, markets are not. And markets are forcing indebted nations to pay ever higher amounts of interest to service that debt.

In its most recent bond offering this past Wednesday, Greece was forced to offer yet another euro-era record yield of 6.47 percent on five-year bonds. By contrast, German two-year debt sold at just 0.29 percent. In 2012, Greece has over €50 billion in maturing debt that will come due, €17 billion of which is in the form of interest payments.

Other, much larger eurozone countries face similar challenges. And if the EU can't come up with enough money to bail out a tiny country like Greece, there's no way it can do it for a big one like Italy or Spain. The resources simply are not there.

The only way out is to “reset” the debt by forcing these countries into default. This approach also makes it possible to redirect the bailout fund money to the bondholders, thereby softening the blow to the financial system.

Forcing the default of one or more Eurozone countries is a drastic move, but it is necessary to safeguard the remaining members. Under the current approach, even the strongest economies will eventually be bled dry as investor confidence deteriorates and bailout costs rise.

Whether  governments have the political will to act in such a decisive manner is a different matter. Nevertheless, the realization is dawning that in the near future, the eurozone will be a different place than it is today. The question is whether this change will be the product of reasoned policy for the betterment of all, or a collapse that a wise economist predicted years ago. 

– Scott Boyd is a currency analyst with OANDA, a Forex trading company with offices in New York,Toronto, Singapore, and Dubai, and contributes to the company’s MarketPulse FX blog.