The second choice - in which some or perhaps even all Eurozone members would ditch the currency - would cause all sorts of economic hardship. Changing currencies from the Euro to some new national currency would be a chaotic process. A country would most likely need to freeze bank withdrawals and convert the currency denomination of contracts. So, if someone had 30,000 Euros saved in the bank and still owed 9,000 Euros on a car loan, both balances would be legally converted from Euros to the new monetary unit. This new currency would be worth less than the Euro. Families that had been saving money in banks could see the value of their savings slashed. Investors would flee in the short term and quite possibly stay away for years, leading to a dearth of capital to fund investment in new businesses. Because many contracts denominated in Euros involve parties from more than one country, some very thorny legal issues would arise about what currency the contracts should be denominated in going forward.
Throughout the financial crisis, policy makers have employed scare tactics to justify aggressive interventions and bailouts: If the banks are allowed to fail, economic catastrophe would result. If Greece defaulted, the entire financial system would collapse (a contention that seems inconsistent with Europe's latest rescue plan, which calls for banks to "voluntarily" concede a 50% haircut on their Greek positions). I suspect that European leaders portrayal of only two options - fiscal union or Eurozone breakup - is yet another scare tactic. A Eurozone breakup would indeed be chaotic. But it is hardly the only viable alternative to fiscal union.
A country can default within the Eurozone. In reality, Greece already has. Banks have agreed to accept less than they are owed on Greek government bonds. The Euro is still around.
The argument that a country cannot default within the Euro system remains one of the least thoroughly explained notions in current policy debates. Perhaps the best explanation I've seen of such logic appears in The Economist:
If a messy default is forced upon a euro-zone country, it might be tempted to reinvent it own currency. indeed it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social un-rest, high borrowing costs and baking chaos seem likely either way.
In other words, a country might prefer to simply convert all contracts into a new currency and print that currency to service debts. Unfortunately, this would most likely lead to massive inflation and capital flight, causing families to suffer a severe loss in the value of their savings, among many other unwanted consequences of high inflation. There is little reason to think that citizens would actually be better off.
The fact of the matter is that Greece cannot honor its debts and should haircut them even more than it already has. Owners of that debt will suffer losses. The Greek banking system may need to be recapitalized. All of this can be done within the Eurozone without imposing severe hardship on the Greek people, though they will have to stop spending above their means. By writing down the debt, the amount of austerity required will be greatly reduced.
Banks and politicians are arguing that if the people of Europe do not use their money to avoid defaults and rescue the financial system, calamity will ensue (in the form of a chaotic Eurozone breakup). However, this argument is unconvincing. It is easy to imagine a country applying a haircut to its debt while continuing to use the Euro. Such a result will lead to some bankruptcies and a significant loss to investors. But it need not lead to economic chaos. It has the added benefit of bringing back some level of fairness to the financial system. Investors who chased profits without properly accounting for risks should not be made whole at everyone else's expense.
None of this is to say that a default within the Eurozone will be a simple and painless affair. But for countries that are unable to honor their debts (Greece certainly and maybe Portugal and *Ireland), it is the best path forward.
*Ireland actually entered the financial crisis in decent fiscal shape. Only after assuming the liabilities of financial institutions did the government find itself mired in debt. The people of Ireland would be far better off today had their government not acquired massive debts in order to bailout bank investors.
