The euphoria with which markets responded to Chancellor Merkel’s concession to Mario Monti was again a brief happy moment after years of growing despair. I am appalled and dismayed by the self-serving arguments puts forth almost daily in the Financial Times by bankers and bond market speculators, with George Soros taking the lead. To listen to them, the solution for Europe is to bail them out by getting the fiscally responsible governments to assume the debt of the profligate countries.
This is a new twist on the age old pressure to use the rich to subsidize the weaker parts of society. The only new aspect is the involvement of international organizations in a not very subtle attempt to hide the fact that Germany, Netherlands and Finland would pay. The citizens of those countries are not fooled.
Ask the important question: Would a transfer of debt from Spanish, Italian and other banks to multi-national agencies bring an end to the horrible recession in these countries? It didn’t work for Greece, and it didn’t work that way in the U.K. or the U.S. when governments shifted banking losses to taxpayers. Certainly a smaller debt would enable the heavily indebted countries to borrow on more favorable terms when they rollover their debt or finance deficits. But the principal benefit goes to the bankers who unload their Spanish and Italian bonds on the public. That surely will not end the contentious argument about who pays and who gains. It just moves it to a new venue.
One of the worst results of debt bailouts is that more of the outstanding debt moves to places where haircuts will be less likely. Governments are reluctant to reduce the value of privately held debt, but they are much more intransigent about reducing the value of their assets. That’s a sure way to make the problem more durable. But it avoids additional losses for the bankers, so they continue to present schemes for relieving their losses.
The overly generous welfare states in France and in southern Europe cannot expect to get the bailout that would relieve them of the unpleasant task of recognizing that they have promised more than they are able to deliver. Prime Minister Thatcher famously said that the end of the welfare state would come when they ran out of other people’s money. The heavily indebted countries were cheered by the concession Chancellor Merkel made at the last summit. They want to believe that they have found a new source of funding. They hope that it will be the first of many such concessions. The German public does not share their hope. Fortunately It is committed to fiscal probity, so it is unlikely to hear their fervent prayers.
Growth Not Redistribution Is the Answer
How can Europe bring its recession to an end? The northern countries have contributed large sums without much evidence of increased growth in the heavily indebted countries. More redistribution from north to south will not solve the problem. The advocates of a pro-growth policy have the right idea but the wrong strategy. A sustained program of renewed growth cannot occur unless costs of production in Greece, Italy, Spain, and Portugal are reduced substantially. Those costs are from 25 to 30% higher in the troubled countries than in Germany. There are only two ways that wage costs can be reduced in a fixed exchange rate system. Either governments force wage reduction that lowers real wages or countries leave the fixed exchange rate system temporarily and devalue their currencies.
Germany promotes real wage reduction and labor market reforms. I see two insurmountable problems in the German proposal. After three or four years of recession, the indebted countries would be required to reduce real wages by 25 to 30%. That requires the workforce to accept a real wage reduction spread over time that is like the reduction experienced in the Great Depression of the 1930s. Elections in Greece and France show a distinct unwillingness before the strategy is in place. I do not believe that reducing real wages through austerity will be politically acceptable. The other big problem with the German plan is that political agreements to introduce market reforms are much more difficult to obtain when an economy is in recession.
Getting people to give up their protected positions is not easy at any time. But it is easier if they can believe that, in a growing economy, their sacrifice of protection will not result in their job loss. That implies that the much needed reform of labor and product markets should come after growth resumes.
The European crisis reinforces my strongly-held view that it is difficult, perhaps impossible, to maintain fixed exchange rates in a modern democracy. Political pressures for increased government spending and deficits create the problem. Nevertheless, the ECB countries say they want a fixed exchange rate system. I have taken that as a restriction on my recommendations.
I propose that the euro using countries split the euro into a strong and a weak euro. Greece, Italy, Spain, and Portugal, probably soon joined by France, would create a new currency—the soft euro. The remaining countries would retain the existing euro and would enact the fiscal rules on which they agreed. That would further strengthen the hard euro, if the fiscal reform is enforced.
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.
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.