Hoover Daily Report

Leave the Euro to the PIGS

via Wall Street Journal
Wednesday, September 14, 2011

The European debt crisis spreads and worsens. The G-7 met last weekend and did nothing useful. The European Central Bank's chief economist, who was the German representative on the ECB, resigned last week to protest the bank's purchases of Italian and Spanish debt. My congratulations to him for reaffirming principles that the ECB was organized to support. The president of Germany's Bundesbank, the very able Axel Weber, resigned last spring because he did not support the policy of buying long-term debt of overindebted countries. He too chose principle over expediency. The long-term debt purchases continue.

The Europeans keep throwing money at problems and insisting on short-term palliatives. They are too willing to spare the bankers for past mistakes by trying to shift the cost of bad debt to unwilling taxpayers. Many propose a "European bond" to hide the fact that they want to shift the excessive debt contracted by the spenders to the more fiscally prudent. The current ECB acts on the belief that all problems can be solved by bailouts.

The ECB agreement to develop a common currency began as an agreement that France would accept Bundesbank rules in exchange for a seat at the table. Other countries agreed to the rules for maintaining price stability when they joined. But the agreement has been violated so often in the current crisis that it is dead, replaced by bailouts and fiscal actions, including purchases of long-term debt by the ECB.

Lending more money to Greece will not end Greece's problem. Greece cannot meet the budget targets set by its agreements with the European Union and the International Monetary Fund (IMF). A core problem is the wide gap between average worker's productivity and the average real wage. The difference is about 15% to 20%; that's the amount by which productivity must increase or real wages must fall to achieve equilibrium.

Since there is no chance that in Greece's state-controlled economy productivity can increase enough to close the gap, there are two outcomes left. One is to remain with the euro and deflate prices and wages 2% or 3% a year for six to 10 years. The other is to devalue the currency (as Greece has done several times in the past). Good luck to those who think any government could endure six or more years of deflation.

One thing is certain: Higher real-estate taxes or income taxes, among other proposals being floated in Athens, will not solve the Greek problem. Nor will a few sales of state-owned assets followed by large layoffs.

Another proposed alternative is another loan from the International Monetary Fund. Yet that delays resolution without solving any problem, and it shifts part of the cost to the countries that pay large shares into the IMF, such as the U.S., Britain and Japan, which have their own severe problems.

And then there is Italy, which has had low growth for a decade or more. Asian competition was too much for many small manufacturers of shoes, textiles and other products that Italy used to export. Italy continues to waste its potential by spending on low-productivity, politically-determined transfer programs. A currency devaluation would help to align Italy's costs with current world conditions. Government spending reductions would free resources for higher productivity uses.

Although the European Central Bank treaty does not permit devaluation, there is a way for Greece, Italy, Portugal and perhaps others (known by the acronym PIGS) to devalue while remaining part of the euro. The northern countries can start a new currency union limited to those who adopt common, binding or enforceable fiscal arrangements like those that German Chancellor Angela Merkel and France's President Nicolas Sarkozy discussed last month. The new currency could float against the euro, allowing the euro to devalue. Once devaluation restored competitive prices in the heavily indebted countries, they could be admitted to the new currency arrangement if, and only if, they made an enforceable commitment to the tighter fiscal arrangement. If all countries rejoined, the old system would restart with a more appropriate, binding fiscal policy rule.

Bondholders would suffer losses from devaluation. Banks that are threatened with insolvency should be permitted either to fail or to borrow from their governments on loans that must be repaid.

We have had enough clever schemes to protect bankers by shifting the cost of profligacy to the prudent citizenry. A permanent solution to the European debt problem requires a lot less finger pointing and much greater efforts to bring an end to the excessive debt and deficit spending. Spare the taxpayers, not the bankers. Let the market work to end the problem by devaluing the troubled currencies.

Mr. Meltzer is a professor of public policy at the Tepper School, Carnegie Mellon University, a visiting scholar at the Hoover Institution and author of "A History of the Federal Reserve" (University of Chicago Press, 2003 and 2009.)