It’s often difficult to comprehend – much less internalize – the risks posed by the European sovereign debt crisis.

But understand this: If Europe’s problems aren’t resolved in an orderly fashion, the stock market drops we saw last month will be small potatoes compared to the steep declines that lie ahead.

So here’s the solution: Let the Eurozone break up right now on its own terms. And let a new, stronger euro currency come as a result.

At this point, that is the only viable solution to the problems Europe faces.

So far, everything the European Union (EU) has done to try to subdue this outbreak has come up short. In spite of all the group’s efforts, the European sovereign debt crisis continues to snowball, drawing more and more countries into the fold as it gathers momentum.

[ad#Google Adsense 336×280-IA]The trendy solution is to simply expel the weaker members of the Eurozone. That would work if Greece was the only problem, but it’s not.

That’s why a better solution would actually be the opposite – for the stronger countries to abandon the euro and create their own currency.

European countries with strong economies – Germany, the Netherlands, Finland and Sweden – should simply walk out.

I’d like to take credit for breaking new ground with this idea, but I can’t. Former head of the Federation of German Industries, Hans-Olaf Henkel, writing in the Financial Times recently proposed this alternative solution as well.

Still, it’s worth subscribing to for a number of reasons.

To begin with, it would absolve the strong countries of their liability to prop up their weak Mediterranean sisters.

It was one thing when only small countries, such as Greece, Ireland and Portugal needed propping up. But now Spain, with a collapsed housing bubble and eight years of bad management, and Italy, with the most debt of any country in the EU, are at risk. Both of those countries’ economies are large enough to put a sizeable dent in even Germany’s vast wealth.

Even more ominous, storm clouds have started swirling around France, which is still rated AAA but does not deserve to be. The country has not balanced its budget since the early 1970s, and public spending has soared on the back of hopelessly uneconomic schemes such as the 35-hour workweek.

Now the French government has come up with a supposed solution – one that consists entirely of tax increases.

So it’s clear now that something must be done. And the solution I support has benefits for both strong and weak Eurozone countries.

The Benefits of Breaking Up

For the stronger countries, leaving the Eurozone voluntarily and forming a new, stronger euro currency would have three immediate advantages.

  • First, since a number of countries would be involved, it would be a chunky currency, so speculators would not be able to drive it up to absurd levels and kill off exports.
  • It would also allow the strong euro countries to manage their own monetary policy. That would wipe out the inflation threat and ensure that domestic savers were adequately compensated. It also would eliminate any need for bailouts among these countries.
  • Finally, it would preserve the advantages of a foreign exchange free zone between these countries, so that transfers would remain cheap, without additional forex costs.

However, there are also benefits for the countries that stick with the euro, which would presumably weaken.

These countries would not incur the stigma of failure that they would by leaving the euro themselves, yet its new weakness would improve their competitiveness. It would push up their economic growth rates and make it easier to bring their governments back into shape.

Their inflation rates and interest rates would be higher, of course, as was the case for the Mediterranean countries before the euro was invented. However, their debts would remain denominated in euros, so they would not suffer the problems of the Asian countries that devalued in 1998 and increased their debt burdens and bankrupted the banks.

Getting Past the European Sovereign Debt Crisis

It’s likely that Greece’s economy would be too weak to sustain itself even in the weaker euro, so it would have to return to the drachma, and its creditors would have to write off most of their debt. Still, that’s a small problem in the context of the EU as a whole.

An EU with two euros, plus peripheral currencies – such as the British pound, the Danish crown and the Polish zloty – would keep much of the benefits of the euro. For the most part there would only be one large foreign exchange market, rather than 17.

However, the two blocs would be much closer to Robert Mundell’s “optimal currency zones” than the oversized and unwieldy Eurozone. They also could coordinate fiscal and economic policies with each other, rather than ceding more power to the arrogant and unresponsive European Central Bank in Brussels.

There’s a sporting chance that the German Federal Constitutional Court will declare the bailouts of Greece and other countries to be unconstitutional and contrary to the 1993 Maastricht Treaty.

In that case, a new currency bloc will be the only solution to the European sovereign debt crisis. But even without an adverse court decision, it represents a more attractive alternative to endless bailouts of the feckless laggards.

There are, of course, several ways for investors to prepare for the Eurozone’s inevitable disintegration.

Right now exchange-traded funds (ETFs) represent the best opportunity to profit.

The two best economies are Germany and Sweden, so at the very least you should consider the iShares MSCI Germany Index Fund (NYSE: EWG) and the iShares MSCI Sweden Index Fund (NYSE: EWD).

Sweden is a member of the EU but doesn’t use the euro. And Germany’s economy will perform even better than it does now if it’s ever liberated from the freeloaders it currently carries on its back.

— Martin Hutchinson

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Source:  Money Morning