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Wanted: A radical idea to fix the eurozone

September 28, 2011: 11:02 AM ET

Here's one: European leaders could save Greece with a big enough bailout to put it back on track, and then take a cut of its growth in future years.

GreeceFORTUNE -- After a series of efforts to keep Europe's ongoing debt crisis from turning into a worldwide financial disaster, it seems as though little has calmed investors: Greece, Portugal and Ireland are on the brink. Italy and Spain could be next. And while the economies of Germany and France are doing okay for now, even the healthy ones are showing signs of weakness.

Late Tuesday, lawmakers in Athens voted on a hugely unpopular property tax as part of a package of cuts to secure funds for a bailout package. Officials are also working to beef up a fund that facilitates low-cost loans for struggling EU countries.

But even with new powers granted to the European Financial Stability Facility, it's still uncertain how effective it will be. Investors continue to worry that the fund, established last year, won't have enough money if bigger economies such as Spain or Italy suddenly need a lifeline.

Politicians may not be looking for bold ideas at this point, but the markets certainly are, as Europe's debt crisis threatens to plunge the world into another deep recession.

As Gluskin Sheff & Associates chief economist David Rosenberg wrote ahead of Tuesday's vote: The markets want "massive amounts of money thrown at the problem, regardless of who pays (so long as it's not the banks holding the debt!)."

One solution is to give Greece a much bigger bailout in exchange for bigger payments once its heavily indebted economy begins to heal and grow, as Harvard economist Kenneth Rogoff has suggested.

The idea is analogous to what he thinks could help fix America's troubled housing market. Just as homeowners could receive write-downs on their underwater mortgages in exchange for claims on a percentage of future appreciation of their homes, rich countries in Europe could possibly agree to a much bigger bailout for Greece (one, as Rogoff says, that's "actually big enough to work") in return for higher payments later if its economy outperforms.

That way, both borrower and lender would have a stake in seeing the deal succeed. And perhaps more importantly, nobody is really getting a free ride – at least in principle.

In the case of the U.S. housing market, this would potentially mean a win not only for homeowners who owe more on their homes than their properties are worth, but also a win for lenders and investors who would eventually be repaid for giving borrowers a break. Conversely, Europe's heavily indebted peripheral countries would get meaningful relief on their debt payments. Once these economies grow in healthier fashion – say 10 to 15 years from now – taxpayers would repay the rich countries via a portion of its GDP gains.

Rogoff hasn't elaborated much beyond this, but it's almost assumed that any such plan would include easing austerity measures that the European Central Bank and International Monetary Fund have forced on Greece in order to secure its bailout money. These measures have created a double-edge sword for Greece, since it can't possibly repay the loans if it can't grow.

True, it makes sense for a nation with huge debts to cut spending. But laying off thousands of workers and raising taxes has proven devastating on the Greek economy. GDP has shrunk more than anyone expected, falling 6% in 2010 and 7.3% during the three months ending in June. A further decline in growth could cause Greece to miss revenue targets and even seek more bailouts, which is largely why the market is pricing in the likelihood that Greece will eventually default.

Greek bonds have plunged, putting the chance of default at more than 90%, according to Bloomberg. Two-year notes yield more than 70%.

Now back to Rogoff's idea of giving Greece what would essentially be a long-term loan with delayed payments -- it has its drawbacks. Politicians would likely be against it, at least today. Germany is clearly fed up and resents having to be Europe's banker of last resort. And even though Germany could get substantial returns for funding bigger bailouts, this could still easily be viewed as rich states giving handouts to poor states that haphazardly spent beyond its means.

The problem isn't just getting rich countries on board, however, says Alan Deardorff, associate dean of University of Michigan's Gerald R. Ford School of Public Policy. Greece would need an incentive to agree to what would essentially create a tax on any rise in income. Indeed, any collection on future GDP growth would have to be limited to a certain percentage so that Greece would have an incentive to grow its economy. And growth, at least in the long-term, would depend significantly on deep structural reforms in the state's economy.

Nevertheless, if Rogoff's idea may not be politically feasible today, it's at least intellectually appealing. And something perhaps worth considering later.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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