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European leaders and markets have something in common when it comes to acknowledging financial and economic risk emanating from the continent, Nobel Prize-winning economist Joseph Stiglitz told CNBC on Wednesday.

They have their heads in the sand.

Following a brief dip in the wake of Britain's vote in June to leave the European Union, UK stocks have moved sharply higher, and US equities have struck new all-time highs. But markets are underpricing risks that include growing distrust of pro-EU centrist leaders amid widespread youth unemployment and a euro that has been proven a failure, Stiglitz said on CNBC's "Squawk Box."

He criticized European leaders, including European Commission President Jean-Claude Juncker, who appear set on pushing a message that any country that leaves the union will be punished.

"That's the kind of idea that says the only way we're going to keep people together is not through the benefits we give, but through the fear of leaving. That's not a healthy attitude, and that will speed the breakup," he said.

Further, Stiglitz said European economic statistics since 2008 have been "dismal."

"The best-performing country, Germany, would be given a D if it were not for comparison with how bad the rest of Europe is doing," he said. "In that context, it's inevitable that there's going to be large fractions of the population that are going to be upset."

Stiglitz said this has not always been the case, but the European Union's fortunes have taken a turn for the worse since the 28-nation bloc adopted a common currency, which he blames for much of the continent's present-day woes.

In using the United States as an example of a successful union, European leaders didn't look close enough, Stiglitz said. He noted that critics of the euro long ago said the true test of the currency would be a shock to the system, and that shock came during the 2008 financial crisis, from which Europe's rebound has lagged the recovery in the United States.

"There are many factors that go into the success of a country or region. … What we're talking about here is one single policy change, the creation of single currency, which has had a devastating effect," he said.

In years past, countries facing economic crisis have devalued their currencies to stave off financial collapse, but the adoption of the euro took that measure off the table, complicating the response for countries with vastly different growth rates and economies across the EU.

The EU made a mistake by prioritizing the formation of a currency union over democratizing decision-making and forging a stronger European Parliament to balance the power of the bureaucracy, he said. As a result, he added, the EU is seen as little more than a bureaucracy.

Stiglitz said he is pessimistic European leaders can summon the political will to take relatively simple economic steps to save the euro, such as a creating banking union and coordinating fiscal policy.

In his view, one alternative to a divorce is a "flexible euro" that would bind smaller regions of Europe with more similar economic growth rates into smaller currency unions. That could result in the adoption of a northern and southern euro, he said.

In that scenario, the greater European Union could revisit the idea of a broader currency union if the requisite institutions develop and if exchange rates between the multiple euros converge, he said.

First Published:Aug 18, 2016 8:21 AM IST