BEIJING ― With the likelihood of a contagious sovereign-debt implosion and European bank failures greatly reduced by the Greek debt deal and the European Central Bank’s lending program, it is time to look ahead. Where do the European Union, the eurozone, and the EU’s highly indebted countries go from here? Will Europe be able to roll back its welfare states’ biggest excesses without economic distress and social unrest toppling governments and, in the peripheral countries, undermining already-tenuous agreements with creditors?

Some good news globally will have an impact on how these questions are resolved. The United States’ economy is gradually reviving, albeit slowly by the standards of recovery from a deep recession. China, Brazil, and India have not decoupled from their customers in Europe and North America, and so are slowing, though a relatively soft landing is likely if Europe’s recession is as short and mild as predicted.

The EU’s economic output and population are larger than that of the U.S., so the fate of the 27 EU countries is everyone’s business, from New York to New Delhi, Sao Paulo to Shanghai. Formed originally as a free-trade area, the eurozone comprises 17 of the countries. Knitting together 17 disparate economies, cultures, and institutions was a monumental undertaking, fraught with risk.

The Lisbon Treaty emphasizes unanimity in decision-making. With some members inside of the eurozone, and others remaining outside of it, and with disparate economic interests and monetary and fiscal traditions even within the eurozone, agreement is difficult. That sets the stage for three broad scenarios, each with implications for the European and global economy, the financial and banking system, and relations between the member states and EU institutions.

In the first scenario, a more united and homogeneous Europe emerges from the crisis, enforcing greater restrictions on member states’ budgets to reduce apparent risk. Accompanied by a strong, broad eurozone, risk of a future currency crisis remains.

In the second scenario, a two- or three-tiered Europe includes a two-tiered euro, with the weaker countries using a separate “euro-B” currency that can float against the stronger economies’ “euro-A.” This arrangement would hold out the promise to fiscally stressed economies that, if they get their act together, they could rejoin euro-A ― and do so more readily than they could from their own currency.

In the final scenario, what emerges is a more decentralized Europe, with less top-down agreement in areas beyond trade and a smaller, more homogeneous eurozone composed of the EU’s core economies. Such a construct would be far more popular with citizens who are unhappy with the accretion of EU power in Brussels and the loss of traditional sovereignty. Some current euro members ― Greece (and perhaps others) ― would revert to national currencies.

None of these options is easy; each entails serious difficulties and great risks. Episodic muddling through may be the best that can be hoped for.

For example, how would Greece (or any country) exit the euro in order to cushion the extreme downward wage adjustment required to regain competitiveness, and to avoid the severe social unrest that could result from reining in debt too rapidly? As soon as word got out that Greece was seriously considering such a move ― well before it could even generate a new drachma currency ― euro bank deposits would flee Greece.

As a result, Greece would be forced to impose capital controls. Some contracts denominated in euros would be subject to Greek law, some to European law, and others ― for example, derivatives contracts ― to British or U.S. law. Legal chaos would result. Yet sticking to the euro and forcing all of the adjustments in wages risks greater unrest; indeed, it might merely postpone the inevitable.

Governments and the bond market will test the seriousness of the newly agreed fiscal guidelines (if they are ratified). While talk is tough now, the history of such agreements does not inspire optimism. Before the financial crisis, even Germany violated the EU Stability and Growth Pact’s (SGP) deficit limits. In the U.S., the 1980s deficit limits set by the Gramm-Rudman-Hollings law were not met, and, like the SGP, were revised and extended. Agreements with, and access to, the International Monetary Fund and Europe’s new bailout fund provide (soft) constraints.

Regardless of how these governance and fiscal issues are resolved, or muddled through, Europe’s banks remain a thorny issue. With the time afforded by the ECB’s three-year cheap loans, they have some breathing room to rebuild their capital and clean up their balance sheets. But, while doing so, they are not likely to be expanding private-sector lending to support economic growth. European banks are far more thinly capitalized, and account for a much larger share of credit extended, than banks in the U.S., where much more lending originates in capital markets.

Most large U.S. banks ― Citi is an exception ― passed U.S. Federal Reserve stress tests recently, with enough capital to withstand a hypothetical deep recession (13 percent unemployment, a 21 percent further fall in home prices, and a 50 percent stock-market decline). Europe’s stress tests have been much weaker. Some sort of Brady bond to reduce and extend excessive sovereign debt will be necessary.

We can expect further European turmoil ― from banks, sovereign debt, and social unrest in response to even modest welfare-state rollbacks ― and clashing visions, within and among countries, concerning the desirability of deeper European integration. Europe has come a long way from the days when its leaders prophesied that the euro would quickly rival the dollar as a global reserve currency.

Yet no one should write off Europe. It still has great strengths, and, with sensible reforms, the EU can survive and eventually return to greater prosperity and stability. But Europe remains closer to the beginning of that process of renewal than to the end.

By Michael Boskin

Michael Boskin, currently professor of economics at Stanford University and a senior fellow at the Hoover Institution, was chairman of President George H. W. Bush’s Council of Economic Advisers, 1989-1993. ― Ed.

(Project Syndicate)