I've seen a bunch of commentators today saying that "the fundamental problem Europe needs to solve is growth, not budget deficits." In some sense this is true--enough growth would solve many of the problems in the periphery. (Usual caveat: Greece is a special case.)
But while it's true, I'm not sure it's useful. For one thing, the euro itself is a major contributor to the lack of growth. Italy and Greece, especially, used to rely on serial devaluation to keep their relatively low-productivity tradeable sectors competitive. Do we have a way to dramatically increase productivity in their small, family-owned farms and firms? Keep in mind that a preponderance of such firms is not simply a historical accident; it's generally thought to be a symptom of fairly low trust levels which make it problematic to hire strangers or invest your money in them.
Greece, Italy, and Spain also have terrible demographics. Their populations are aging extremely rapidly. This is a problem for two reasons First, output is basically Producitivity X Labor Input; if the labor force is not growing, then GDP growth will slow down. And second, there's some legitimate worry that older populations simply have a much harder time innovating and improving productivity than younger populations--older people are more risk averse, and much less friendly to change. While rates of entrepreneurship are high among recent retirees in the US, this is mostly retirees doing a little consulting on the side in their old industry (a net decrease in output), not the foundation of dynamic new growth firms that will move the production possibility frontier outwards.
You can go overboard on the "demography is destiny" stuff, but it may be literally impossible for many of the PIIGS to generate the growth they need.
I basically agree with Merkel's critics that austerity is going to be counterproductive in the short term (though I also realize that it's still necessary in the short term, because there is no way to credibly prove that they will do "austerity later" other than by doing "austerity now") However. There is at this point no conceivable policy scenario which somehow makes Italy and Greece grow by as much as 2% a year for the next few years. I'm not saying that this couldn't happen, mind you--anything can happen! But no one is proposing a policy that will assure it. We're quibbling about how much we should try to make their economies should contract--a little, if the rest of the EU gives them some spending money; a lot, if they do deep cuts right now.
If what we really need is to solve the problem of Italian and Greek growth, then we're hosed. Italy and Greece face some pretty large and intractable problems--one of which is the euro. And even if that weren't true, the record of foreigners marching into a place and whipping its institutions into shape is . . . well, how's that Afghanistan thing working for us?
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