FORTUNE – From the U.S., the European debt crisis can seem like a black comedy populated by regional stereotypes: iron-fisted Anglo-Saxons, feckless Mediterraneans, and haughty Brussels bureaucrats. Closer to the action, it isn’t funny at all. In the words of Mervyn King, governor of the Bank of England, Europe is “tearing itself apart with no obvious solution.”
Pending the second Greek election on June 17, it is hard to make predictions. Many commentators see a Greek exit from the euro as the precursor to a broader breakup. In Brussels some EU veterans argue the opposite. They say that once the euro family has ejected Greece, which has always been a problem child, it will come closer together and forge ahead. Until now, my inclination has been that the Europeans would muddle through, with or without the Greeks. But for that to happen, the continent must find a way to kick-start growth.
Austerity has failed miserably. Outside of Germany, the continent is mired in recession. In seeking to slash their way to a balanced budget, all too many countries have fallen victim to the vicious circle that Keynesian economists warned about: When government spending is cut, demand slumps, firms lay off more workers, unemployment increases, tax revenue falls, and the deficit remains stubbornly high.
More: What a Greek exit means for the U.S.
Many academic economists favor abandoning the euro (or restricting it to Germany and a few other core countries) because that would allow nations like Ireland and Portugal, and even Italy and Spain, to devalue their currencies and give their exporters a boost. That looks good on paper. But a disorderly breakup of the euro would create financial chaos. There would be bank runs, stock market collapses, more political instability, and quite possibly another global recession.
A less drastic option would be a Europe-wide fiscal stimulus, with spending focused on the periphery countries. François Hollande, the new French President, supports the idea, and Angela Merkel, in an interview with CNBC, suggested she was open to it. But even if a stimulus program materialized, it would be modest and temporary. To really get Europe back on track, it would need to be combined with permanent debt write-offs designed to bring the financial burdens of the periphery countries down to more manageable levels.
Debt remains at the root of the problem. If Greece’s second bailout, which was agreed upon in March, had worked as planned, the country would have emerged with a debt-to-GDP ratio of more than 160%, and the interest on that debt would have consumed one in five tax dollars into the indefinite future. Ireland, which has done everything its debtors demanded, is in a similar bind. No wonder voters have tired of austerity.
More: Greece – The anatomy of a default
If the German public won’t countenance forgiving debtors, another solution will have to be found. The obvious one is printing money and inflating away some of the bad debt. In extending a trillion euros of cheap loans to troubled European banks earlier this year, the European Central Bank averted an immediate crisis. Now Mario Draghi, the ECB president and my pick for 2012’s Person of the Year, needs to turn the money hose back on to douse the fire that will ensue if Greece crashes out of the euro and to tackle the broader debt problem. He could mimic the Fed and buy government bonds. He could resume his bank-lending program, which is an indirect form of quantitative easing. And he could issue loans to the EU bailout funds, which would use them to finance further debt restructurings. (For that to happen, the bailout funds would have to be granted a banking license.)
Such policies, if they were adhered to, would eventually lead to a fall in the euro and a rise in inflation, which would be all to the good. History demonstrates that inflation, rather than austerity, is the best way to deal with a debt mountain.
This story is from the June 11, 2012 issue of Fortune.
