A Greek Tragedy

The Euro, the common European currency that was just a few years ago hailed as a huge success, is in deep trouble. Greece’s problems are actually worse than past monetary crises, such as the 1997 financial crisis that crushed the currencies of the South East Asian “Tigers” or the Argentine crisis of 2005, which broke the decade-long dollar-peso link. The Setting The Euro was designed to replace the national currencies of Europe with a currency that would facilitate the flows of capital, goods, and commerce between European countries. A common currency cuts transactions costs and allows for a common price on which European stocks and bonds are traded. The Euro is managed by the European Central Bank (ECB), which in turn was made up of the governors of the national central banks. At its conception, many economists felt that the participants would be first and foremost Germany, and then France, the Benelux countries, Austria, and some of the Scandinavian countries. It was hoped that Italy would be able to join, but that was by no means considered a certainty. The peripheral countries of Portugal and Spain were considered long shots and Greece wasn’t even on the radar. Nevertheless, Italy, Portugal, and Spain surprisingly squeezed in when the Euro was launched in January 1999, and Greece joined later. Trading began at $1.12 per euro, but after a brief weak spell, the currency appreciated significantly. The ECB proved to be made up of hard-nosed central bankers, who kept stern anti-inflationary watch and appeared immune to political pressures. The currency union was deemed a success and the euro attracted significant capital to those countries that joined the currency union. Housing prices, which were at one time appreciably lower in Spain, Portugal, and Greece, rose sharply. Qualifying for the Euro was seen as a sign that a country had submitted to fiscal discipline and relegated its monetary policy to tough central bankers. In 2007, before the current crisis, the Euro rose above $1.60, a level that priced most European goods and services well above what economists call “purchasing power parity,” or the level that would have been consistent with a comparable cost of living in other developed countries, especially the United States. Wages also rose in these peripheral countries as workers found it easy to compare pay scales in a common currency and demand compensation levels closer to their northern neighbors. Tragedy Brewing But for many of these peripheral countries, there was no corresponding increase in productivity that justified the higher cost structure. As a result, their exports lagged and their imports increased. Although this did not cause a problem during the boom, when the financial crisis hit, those countries that had overspent and underperformed were beset with large trade and budget deficits. Before joining the Euro, the solution for these countries would be obvious. Their currency would be devalued so their cost structure relative to the rest of the world would become more competitive. This solution was not costless: Devaluation raises import prices and inflation and thereby reduces the real income of workers. Yet this was the price paid to return to balanced growth. Those countries that devalued sharply were able to turn their trade deficit into surpluses in a matter of months. But devaluation is not an option once a country abandons its national currency. The only way the economy can become more competitive is to reduce its costs, particularly wages. But it is very hard to break existing wage contracts, and if wages are not cut, unemployment grows and incomes slide. Workers from the depressed regions should move to the more prosperous ones. But this is unlikely to occur. Although theoretically the European Union allows workers to cross borders to seek better opportunities, labor mobility in Greece, with its language and cultural barriers, is far less than needed. Furthermore, there is no “central” government that can provide relief to the unemployed. Conditions for Currency Union Economists have long maintained that labor mobility and income transfers are a necessary condition to form a successful currency union. These conditions are certainly applicable in the United States, which enjoys unprecedented labor mobility and a dominant federal tax system. Even if Greece is bailed out, the conditions that brought about the crisis in the peripheral countries are not alleviated. Certainly, the Greek fiscal authorities must enforce tax laws and reduce its burgeoning deficit. But in the short run these measures will just exacerbate the economic slowdown. The alternative, dropping out of the Euro zone and reintroducing a new national currency, is a worse nightmare. To enter into a currency union is much like getting married without a prenuptial agreement. No one likes to think of the potential problems down the road. But without a pre-planned exit, the breakup will be that much more painful. Greece’s problems could be a drag on Europe for years to come. Ends