Option 1: Do massive bailouts of the PIGS, unleashing enormous moral hazard and removing the incentive to address their unsustainable budget policies. Worst case is that the entire eurozone goes broke.
Option 2: Let the PIGS collapse, triggering bank runs all over Europe, which leads to a breakup of the eurozone and a severe recession.
Option 3: Do 4% NGDP targeting, level targeting, from 2008. Hopefully the various debt/NGDP ratios get more manageable in a few years.
You’ll notice that I do much more blogging on the Fed than the ECB, even though the European situation is currently much worse. That’s because the euro-crisis doesn’t play to my comparative advantage as a blogger. It involves issues like moral hazard, game theory, budget theory, one-size-fits-all policy problems, etc, where I have no special expertise. So I’ll link to some other bloggers who handle these issues better than I can:
1. Here’s Tyler Cowen explaining why we shouldn’t expect Germany to bail out the PIGS. Tyler mentioned that the German debt is nearly 80% of GDP, but could have added that the GDP if the PIGS is much bigger than the German GDP.
2. Here’s Matt Yglesias explaining why the “huge monetary and social costs” of a bit more inflation are tiny compared to the “huge monetary and social costs” of a deflationary collapse of the eurozone.
3. Nick Rowe explains why a somewhat more expansionary policy would actually make the future value of the euro much less uncertain.
4. Bill Woolsey argues that the central banks should focus not on being a “lender of last resort,” but rather accommodating changes in the demand for base money in order to keep NGDP growth on target.