EXCLUSIVE: Mohamed El-Erian on Europe's Future

My biggest surprise of 2012 was that Europe's financial system didn't blow up. One year ago, few would have predicted the region would do as well as it has.

But the story isn't over. Europe's finances are in disarray, and utterly unsustainable. Something needs to change, and something will change before long.

But what?

Last week, I asked Mohamed El-Erian, CEO of bond giant PIMCO, to describe the top three scenarios he sees happening to Europe. He mentioned a dark bit of historic context:

I remember Argentina December 2001, when this country defaulted, when it exited the currency peg. It wasn't a decision made by Argentina, nor was it a decision made by the IMF. It was a decision made by people rioting the street and killing each other.

Here's what else he had to say. (Transcript follows.)

Morgan Housel: If you were to put three scenarios for Europe today, what would those scenarios be?

Mohamed El-Erian: So let me tell you what should happen -- what's likely to happen and what we fear most. What should happen is Europe should recognize that the current 17-country membership of the eurozone does not make sense, does not work. It doesn't work for individual countries like Greece, who can never get to debt sustainability and growth within the eurozone. And it doesn't work for the larger countries like Germany, where the citizens will not subsidize forever a Greece, so Europe should evolve into a smaller, less imperfect eurozone, reinforced by not just monetary union, but fiscal union, banking union, and greater political integration. That is what should happen. That is assuming policymakers are both rational and courageous. It's not likely to happen very quickly, because no one wants to go down in history as having made the decision for a country to exit the eurozone.

So the second scenario is that they're going to try to muddle through what I call No Peace and No War. So the ECB [European Central Bank], by use of its balance sheet, shows that there's no outright war like there was in July, when yields for Italy and Spain were above 7%, but you get no peace, either, because neither growth resumes, nor do the debt issues get resolved once and for all.

And then the third scenario is they lose control. And they lose control not because they decide to lose control, but because the populations no longer trust them. I remember Argentina December 2001, when this country defaulted, when it exited the currency peg. It wasn't a decision made by Argentina, nor was it a decision made by the IMF. It was a decision made by people rioting the street and killing each other.

So our three scenarios are a good outcome after a very bumpy journey, an attempt to muddle through and a very disorderly breakup. Those are our three scenarios for Europe.

Morgan Housel: What probabilities would you put on the three?

Mohamed El-Erian: I knew you'd ask me that. So it depends on the time. So if you tell me the next 12 months, I will tell you a muddle is a 60% probability and the other ones I would put equally at 20 and 20. If you take the next five years, I will tell you that a muddle through is a very low probability, OK, and it becomes -- think of the distribution becoming very barbelled. Either this is a really good outcome or a really bad outcome. So the expected distribution of outcomes is going to vary, and that's why so many people are paralyzed. Because we as human beings like operating with very simple bell-shaped distributions that have very thin tails, and in Europe, the tails are quite fat.

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