Martin Wolf argues with usual clarity that the EU bail-out is a temporary measure: the Eurozone imbalance remains. The imbalance is between high-savings in Germany and high-borrowing in the south. Prices - wages, houses, consumer durables, everything, really - in the Meditterranean rushed towards German-level prices; so borrowing looked cheap there. German domestic demand remained very depressed - no one really knows why Germans are not spending or investing their incomes domestically, but they're not. If the south had not borrowed, there would have been recession in the south and lower export demand in Germany. Of course, the south should not have borrowed for the projects it did, and the banks should not have oiled the wheels of the whole thing with lashings of deception and wishful thinking. But the truth remains: the convergence of prices led to imbalance, and that has not changed. The magic of flexible exchange rates - abusable also, by the way - is that prices can be made to diverge so easily in the face of these sorts of pressures.
One solution, as Wolf points out, is to mimic devalutaion in the south by having governments impose price and wage reductions for non-traded goods. (Presumably, Germany could also impose price and wage increases in the non-traded sector, but that, oddly, might be even harder than imposing pain in the south). But this will seem grossly unfair: concentrate all the pain of adjustment on one group, and not a particularly well-off group at that, when the benefits from the historical imbalances are kept whole in German pension plans, banking bonuses etc.
The pressure to balance the fairness of the adjustment process will be very strong: the south still has the option to default on existing debt, stop paying the interest, and force the Eurozone (plus Sweden and Poland, who have signed up to the stabilisation agreement) to trigger its loan guarantees. Ultimately, default in the south would destroy the Euro.
So what lies ahead is either a nasty break-up of the eurozone or some concessions from the north. The natural way to ease the adjustment pain is through fiscal transfers from north to south, together with promises that the south will be responsible, for example by reforming clientelist politics, protective labor laws, etc. Someone needs to oversee that the deal is kept, so expect Brussels to ask to check and vet tax policy and the progress of reform. Of course, once such power is truly vested in Brussels – now here would be a significant relocation of sovereignty, nothing compared to the euophobe fear-mongering we are so used to in the UK – the pressure on the European Parliament to exercise more oversight will grow. As IMF president, Dominque Strauss Kahn, institutionally but not ideologically separate from the maximalist European dream, makes the position clear: "What you need is stronger surveillance and tools to organise transfers from one part of the area to other parts.”
This is the essence of the scenario that has the current euro trouble as the brith-pangs of a political Europe. The big question is this: will democracy be shoed in by the currency, or will the currency break apart and follow the (national) democratic institutions? And further, if democracy is constructed around currency and financial criss, will it create good institutions?