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The EU’s Problems

di - 17 Gennaio 2013
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The soft euro would promptly float down against the hard euro. That would quickly reduce real wages in the heavily indebted countries and restore competitiveness. These countries would commit to the needed market reforms and, if they chose, they could adopt the fiscal restraints that Germany demands. After adopting these changes, they could rejoin the hard euro. The soft euro would end. Countries would either rejoin the hard euro or, if they chose, reintroduce a national currency.

Devaluation is a familiar response from the past in each of these countries. It avoids the long delay and political difficulty of reducing real wages. And it restores growth. Market reforms and fiscal responsibility increase the probability that growth will be sustained.

Problems

There are no free lunches. I see several big problems, if some form of my proposal were adopted. First, it would greatly reduce the real value of the debts owned by foreigners. Many French and German banks would take large losses. Some would be insolvent. I believe that is a main reason that devaluing to restore competitiveness is rarely mentioned in policy discussions.

To prevent the banking problem from starting a new crisis, the German and French governments should offer a loan package for their banks. Banks would be told to raise half the addition to their capital in the market. Governments would agree to lend the other half at concessional interest rates. To increase bankers’ incentives, the banks would be told that if they failed to obtain capital in the market, they would be considered insolvent and taken over by the authorities.

A second, big problem is to prevent a run on bank deposits when the split euro is announced. Temporary exchange controls would be needed in the devaluing countries. The ECB should announce its commitment to a lender of last resort policy. No one that offers acceptable collateral would be denied euros.

Third, I have not proposed any bailouts or debt reductions. That puts the proposal far down on the bankers’ list of things to do. They want to be bailed out, so they would likely dismiss anything that doesn’t do that.

Fourth, devaluations are often followed by inflations when the devaluing country allows prices to rise following devaluation. The central bank for the soft euro, not the individual countries, would have to prevent the inflation. If it failed, devaluation would not have a lasting benefit.

Is my proposal ideal? No, fixed exchange rates, bank insolvency, and exchange controls are far from ideal. I don’t think that’s the right question. Would it move the EU countries from prolonged recession toward renewed growth? Yes. Would it strengthen the euro system? Again, yes. Would it end the political wrangling over who pays and who benefits? I hope so.

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