Europe’s monetary union is screeching towardthe abyss, unintentionally,but apparently inexorably. Greece willmost likely not meet the criteria to receive further financial assistance fromits eurozone partners and the International Monetary Fund. Europeans will thenneed to decide whether to let Greecego. The exit option would not improve Greece’s chances of successfuladjustment, and it would come at a steep pricefor the eurozone: it would be “in the money”– and priced accordingly.

A Greek exit could, one hopes, be managed. The European Central Bank wouldcontain the collateral damage by flooding Europe’sbanking system with liquidity (against subparcollateral). Or it will reluctantly re-launchits purchases of public-sector debt in secondary markets, capping the other peripheral eurozone economies’interest-rate spreads relative to the core.

Thus, dire circumstances would once again force the ECB’s hand. As thestrongest European institution, it is systematically vulnerable to being taken hostage, compelled to underwrite a further leaseon life for the euro. In this light, ECB President Mario Draghi’s recent vow todo “whatever it takes” to save the euro came as no surprise.

Back in 1999, it seemed that Jacques Rueff, an adviser to Charles deGaulle, had been vindicated: L’Europe sefera par la monnaie. Eleven European countries chose to give up theirnational currencies (or, more technically, the nominal exchange rate).

These countries understood “one money” as a quasi-physical corollary of “one market.” Independent nationalmonetary policies in a common market were rightly seen as infeasible, given Europeans’ preference for stableexchange rates and open financial markets. This called for a single currency– and thus shared responsibility for monetary policy.

Today, however, we may need to re-phraseRueff’s axiom: Et l’Europe se défait parles marchés financiers, unless, that is, Europecomes up with a viable institutional design.

Given the euro’s current travails, itis instructive to recall arguments stressed in the run-upto monetary union. As the Nobel laureate economist Robert Mundell and others spelled out in the 1960’s, relinquishingnominal exchange rates emphasizes three alternative mechanisms to cushionregional adjustment: inter-regional fiscaltransfers, intra-union migration, and, most importantly, labor markets capableof adapting to shocks.

Unfortunately, these mechanisms were anathemaat the time. Conveying the message that nothing would have to change appearedto be far more attractive.Thus, Mundellian arguments were not heeded when the euro’s institutional blueprint wasconceived. Indeed, the Stability and Growth Pact, like Europe’sno-bail out clause, ignored the pertinent economic theory (some say anyeconomic theory). Regional current-account balances were interpreted as the upshot of infallibleoptimizing behavior by market participants, rather than, for example, theresult of a real-estate bubble in Spain and elsewhere.

Only after the fact, since the fall of 2009, has it become conventionalwisdom that those intra-union current-account deficits, accumulating over adecade, were untenable. Now, given monetaryunion, the adjustment must be carried out by changing domestic prices relativeto tradable goods – that is, by engineering a depreciation of the real exchangerate.

In view of the quite substantial overvaluation in some peripherycountries, this will be a time-consuming process. (Germany needed almost adecade to adapt to a smaller property bubble in its new eastern Länder inthe early 1990’s.) Butit is difficult to imagine that market participants will have the requiredpatience. That is why supporting the euro requires forceful and credible crisiscontainment – whatever it takes.

But the ongoing crisis also highlights a second design flaw, unacknowledged in Mundell’s argument: thechallenges arising from integrated financial markets (including those for thecredibility of the no-bail out clause).Under normal circumstances, unimpededcross-border capital flows come with all of the advertisedbenefits in terms of better resource allocation and higher productivity. In thewake of the crisis, however, given the shared fate of national governments andbanks, a significant home-bias re-emerged.Ring-fencing became national supervisors’ default option, and monetaryconditions became re-segmentedalong national lines.

This translates into a significant disparity in financial institutions’funding costs. The immediate upshot is a substantial divergence in firms’ costof funds, with many small and medium-size enterprises even losing access tocredit completely. As a result, capital expenditure – already a fragileproposition, given weak demand – has plummeted,triggering a vicious circle of shrinking GDP, lower tax revenues, higherexpenditures, and further destabilization ofpublic-debt positions.

The problem is not only that such heterogeneity in funding conditionsrenders a common monetary policy difficult to conduct. More important, giventhat some regions now face interest-rate spreads that are the functionalequivalent of having their own currencies (without a central bank), someeurozone members might at some point wonder why they should not formalize what is de facto a reality.Market participants already do, to a degree.

None of this is inevitable. The euro was not created for purely economicreasons. If it is deemed a worthwhile project, and is viewed as mutuallybeneficial to all participants, the eurozone could be made viable. In order toachieve this, certain minimum conditions must be met. In addition to flexiblelabor markets, a viable eurozone presupposesa (minimal) fiscal insurance mechanism. And it calls for not only commonfinancial regulation, but also for eurozone-wide supervision of financialinstitutions, including common deposit insurance and a shared bank-resolutionscheme.

This is a tall order. And it will taketime to implement. But the immediate short-run alternative – letting Greece(and potentially others) fall by the wayside– would carry a substantial price. Periphery countries would be forced topay a significant premium to compensate investors for assuming a redenomination (partial default) risk. And, withthat, the eurozone would become as vulnerable as any fixed exchange-rate systemhas historically proven to be.