Charles Robertson of Renaissance Capital -

A German victory at the October 26 summit on the euro is most likely. Given the choice of dealing with European debt, via inflation, default or deleveraging, Germany has pushed hard for a Japanese-style deleveraging combined with German-style structural reforms. A 40-60% default in Greece will presumably be eventually accepted, but Northern Europe will still push for reform in Greece, Spain, Italy and Portugal that follows Germany's own example of the 2000s, and the more recent Latvian and Irish examples of reform.

But this effort to make peripheral Europe more German-like will prove very problematic. Already, Irish officials are unofficially saying that no Irish government can now win a referendum approving a new European treaty - a treaty which Germany believes is necessary to ensure Europe can force "other countries" to stick with structural reforms. Meanwhile German officials are struggling to understand why Greece, Spain, Portugal and Italy are failing to take the required dose of medicine that has worked elsewhere.

The Latvian internal devaluation model is tremendously misunderstood by those suggesting it as a template for Southern Europe. Despite an 18% GDP decline in 2009 and a massive jump in unemployment from 6% in 2007 to 19% in 2010, Latvia has cut its budget deficit from 8% of GDP in 2009-10 to an estimated 4.5% in 2011.

If Latvia could take this economic and fiscal pain, why can't Greece? What this misses is that while Latvian per-capita GDP fell sharply, it had risen hugely in earlier years. If per-capita GDP in cash terms was 100 in the year 2000, by 2007 it had risen to 324, and by the end of this year will still be around 304. And this with a currency that has basically been pegged to the euro since the 1990s. Latvians (with jobs) remain vastly better off than they have been within recent memory.

The Irish model is more appropriate, but may be exceptional. Despite its steep 7% GDP decline in 2009 and massive jump in unemployment from 5% in 2007 to 14% now, they have cut their budget deficit from 14% of GDP in 2009 to 10% in 2011. They have endured more pain than any other county; if we take per-capita GDP in 2000 to have been 100, it was 157 in 2007 and has fallen 22% since then to 123 in 2011. This is the steepest fall by far of any EU economy. Irish per-capita GDP in cash terms is up by only a fifth since the year 2000, and in real terms is up just 5% since 2000.

So, why can't the Greeks be more like the Irish? Perhaps this pain has been bearable for the Irish because they are still richer than the Germans. In 2000, per-capita GDP was 12% above Germany, in 2007 it was 48% above Germany, and in 2011 it is still 9% above Germany. We are all emotionally more sensitive to a loss than to a gain, but we are all also relativists. Maybe what is most important is that the Irish remain 20% richer than the British.

What does this mean? First, Eastern Europe is again the best story in Europe. The Baltics, for example, can thrive again, although they won't boom for a few years, and would be well suited to a core Eurozone centred on Northern Europe. These small open economies with 17-19 years of fixed currency regimes under their belt, have proven their ability to make internal devaluations. Latvia and Lithuania may follow Estonia into the Eurozone within a few years.

Second, Ireland too is suited to a core northern Eurozone. Again its small economy has helped.

Third, within the rest of periphery Eurozone, Italy looks best placed. Unemployment is still just 8%, so there is less political pressure on the government than elsewhere. Growth may be minimal for the next decade, but the Italians are used to this - having achieved just 0.6% annual growth over 2000-2010, inclusive. Per-capita GDP has fallen in real terms by 3% since 2000. Italy's budget deficit of 4% of GDP in 2011 is hardly a disaster. Its total household, corporate and public debt ratio is lower than that of both Portugal and Spain.

Fourth, we should worry most about Portugal, Spain and Greece. Private sector debt in Spain and Portugal is enormous at 200% of GDP, more than double that of Greece. Unemployment is already 12% in Portugal, 21% in Spain and 16% in Greece. Given that unemployment fell in most of peripheral Europe when private sector debt soared, we struggle to see how they can stop further sustained rises in unemployment to unbearable levels. The best-case scenario is that Portugal might follow Greece into a significant default on its sovereign debt, and that Spain advances reforms already seen in Latvia and Ireland, thus enabling the private sector to become more efficient and able to manage its huge debt burden, helped by the low interest rates that would be the likely consequence of Japanese-style deleveraging across the Eurozone. The very plausible risk-case scenario is that the 21% without jobs in Spain make this impossible to achieve, that private sector debt gradually ends up on government books and that Spain suffers Japanese-style debt deflation at best, and default at worst.