Abstract
A sovereign debt crisis develops when lenders doubt that outstanding nominal debt is backed by the present value of future primary budget surpluses. The European Stability Mechanism hopes to prevent default by promoting structural adjustments which improve primary budget surpluses. The author discusses inflation and an orderly default as alternative solutions to the debt problem. Inflation is shown to postpone rather than solve the debt problem, entailing severe macroeconomic distortions. An orderly default following proper recapitalization of vulnerable banks induces only moderate costs to public households, solves the debt problem and may well bring about the real depreciation necessary to balance the current account. This, ultimately, allows the insolvent country to stay in the currency union.
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