Rethink the Euro to Save Economies

As the EU summit meeting convenes, Greece is dominating the agenda much more
than Germany's chancellor Angela Merkel had wanted. This week she has
thrown cold water on the idea that Germany and other EU countries would
take responsibility for helping Greece to roll over some of its debt,
handing that job off to the IMF.

Greece had already proposed a set
of draconian budget cuts and fiscal tightening, but it wasn't good
enough for the Germans. For Greece, turning to the IMF is not
necessarily all that different - in fact, the European commission could
push for even harsher policies than the IMF, as it has done in Latvia -
where the IMF/European commission have presided over Latvia's
record downturn. Latvia has lost more than 25% of GDP since their
recession began, making it the second largest cyclical downturn on
record - and if IMF projections prove correct, it will soon pass the
1929-33 decline of the US Great Depression.

Portugal, Ireland,
Italy, Greece and Spain have a problem very
similar to that of Latvia, and unfortunately the authorities -
local and European - are proposing the same solution. It is not clear
that this solution - which consists mostly of budget cuts, tax
increases, and further shrinking of their economies - will work for
these countries.

The problem is that they have a fixed - and for
their level of productivity - overvalued currency. For the countries
listed above, that is the Euro. As many observers
have noted, if these countries had their own national currencies, they
could allow their currencies to depreciate. This would give their
economies a boost by making their exports more competitive and reducing
imports.

But this is only one part of the problem caused by
their subordination to the Euro. It is not just the impact of the Euro
on their trade that is crushing their economies. The more important part
is that they are unable to use the expansionary fiscal and monetary
policies that would help pull their economies out of recession - or
worse, they are being forced to adopt "pro-cyclical" policies, as in the
case of the budget cuts and tax increases being adopted in these
countries.

All of these countries have low or negative
inflation. Therefore, if not for the Euro and the rules governing the
European Central Bank, they could adopt the kind of "quantitative
easing" that the US and UK have used - in other words, create money
and use it to buy up your own government debt. This could help their
economies recover and lower their long-term debt burden.

Instead,
they are following a programme of "internal
devaluation" - shrinking their economies and increasing
unemployment so as to lower wages and prices relative to their trading
partners. If they can accomplish this, then the hope is that they can
export their way out of the recession (with a boost from imports falling
as well).

All of these economies shrank last year - Ireland led
with a more than 7% decline. All of have them double-digit unemployment
rates - Spain's is now at 20%. The Greek economy fell by less than 1%
last year but can be expected to do worse if it adopts the pro-cyclical
policies now on the table.

The problem is that there is no way to
see when there will be light at the end of the tunnel. Even if some of
these economies return to growth next year, there could very easily be a
long period of high unemployment and stagnation, especially if they
follow a long-term programme of cutting their budget deficits to the
prescribed target of 3% of GDP by 2014.

And it is not clear that
the path of austerity and pain will lead the countries to a point where
the structural problems - ie their inability to compete internationally
with the Euro as their currency - are resolved. This is especially true
if they are forced to cut education and public investment that are
necessary to raise their productivity to competitive levels. So they
could end up in this situation again, perhaps after another spurt of
growth driven by some combination of real estate bubbles,
over-borrowing, and an influx of foreign capital. (In some ways, this
has been the problem of the United States, which has also had
bubble-driven growth for the last two decades - first the stock market
and then the housing bubble. One underlying cause of this phenomenon is
that the US has also had an overvalued currency that makes it
uncompetitive in international markets).

Of course withdrawing
from the Euro has its own costs and risks. But if the alternative is an
indefinite period of recession, high-unemployment, and stagnation, it is
something that is worth serious consideration.