Can the Euro be Saved?

NEW YORK - The Greek financial crisis has put the very survival of
the euro at stake. At the euro's creation, many worried about its
long-run viability. When everything went well, these worries were
forgotten. But the question of how adjustments would be made if part of
the eurozone were hit by a strong adverse shock lingered. Fixing the
exchange rate and delegating monetary policy to the European Central
Bank eliminated two primary means by which national governments
stimulate their economies to avoid recession. What could replace them?

The Nobel Laureate Robert Mundell laid out the conditions under which
a single currency could work. Europe didn't meet those conditions at
the time; it still doesn't. The removal of legal barriers to the
movement of workers created a single labor market, but linguistic and
cultural differences make American-style labor mobility unachievable.

Moreover, Europe has no way of helping those countries facing severe
problems. Consider Spain, which has an unemployment rate of 20% - and
more than 40% among young people. It had a fiscal surplus before the
crisis; after the crisis, its deficit increased to more than 11% of GDP.
But, under European Union rules, Spain must now cut its spending, which
will likely exacerbate unemployment. As its economy slows, the
improvement in its fiscal position may be minimal.

Some hoped that the Greek tragedy would convince policymakers that
the euro cannot succeed without greater cooperation (including fiscal
assistance). But Germany (and its Constitutional Court), partly
following popular opinion, has opposed giving Greece the help that it
needs.

To many, both in and outside of Greece, this stance was peculiar:
billions had been spent saving big banks, but evidently saving a country
of eleven million people was taboo! It was not even clear that the help
Greece needed should be labeled a bailout: while the funds given to
financial institutions like AIG were unlikely to be recouped, a loan to
Greece at a reasonable interest rate would likely be repaid.

A series of half-offers and vague promises, intended to calm the
market, failed. Just as the United States had cobbled together
assistance for Mexico 15 years ago by combining help from the
International Monetary Fund and the G-7, so, too, the EU put together an
assistance program with the IMF. The question was, what conditions
would be imposed on Greece? How big would be the adverse impact?

For the EU's smaller countries, the lesson is clear: if they do not
reduce their budget deficits, there is a high risk of a speculative
attack, with little hope for adequate assistance from their neighbors,
at least not without painful and counterproductive pro-cyclical
budgetary restraints. As European countries take these measures, their
economies are likely to weaken - with unhappy consequences for the
global recovery.

It may be useful to see the euro's problems from a global
perspective. The US has complained about China's current-account (trade)
surpluses; but, as a percentage of GDP, Germany's surplus is even
greater. Assume that the euro was set so that trade in the eurozone as a
whole was roughly in balance. In that case, Germany's surplus means
that the rest of Europe is in deficit. And the fact that these countries
are importing more than they are exporting contributes to their weak
economies.

The US has been complaining about China's refusal to allow its
exchange rate to appreciate relative to the dollar. But the euro system
means that Germany's exchange rate cannot increase relative to other
eurozone members. If the exchange rate did increase, Germany would find
it more difficult to export, and its economic model, based on strong
exports, would face a challenge. At the same time, the rest of Europe
would export more, GDP would increase, and unemployment would decrease.

Germany (like China) views its high savings and export prowess as
virtues, not vices. But John Maynard Keynes pointed out that surpluses
lead to weak global aggregate demand - countries running surpluses exert
a "negative externality" on their trading partners. Indeed, Keynes
believed that it was surplus countries, far more than deficit countries,
that posed a threat to global prosperity; he went so far as to
recommend a tax on surplus countries.

The social and economic consequences of the current arrangements
should be unacceptable. Those countries whose deficits have soared as a
result of the global recession should not be forced into a death spiral -
as Argentina was a decade ago.

One proposed solution is for these countries to engineer the
equivalent of a devaluation - a uniform decrease in wages. This, I
believe, is unachievable, and its distributive consequences are
unacceptable. The social tensions would be enormous. It is a fantasy.

There is a second solution: the exit of Germany from the eurozone or
the division of the eurozone into two sub-regions. The euro was an
interesting experiment, but, like the almost-forgotten exchange-rate
mechanism (ERM) that preceded it and fell apart when speculators
attacked the British pound in 1992, it lacks the institutional support
required to make it work.

There is a third solution, which Europe may come to realize is the
most promising for all: implement the institutional reforms, including
the necessary fiscal framework, that should have been made when the euro
was launched.

It is not too late for Europe to implement these reforms and thus
live up to the ideals, based on solidarity, that underlay the euro's
creation. But if Europe cannot do so, then perhaps it is better to admit
failure and move on than to extract a high price in unemployment and
human suffering in the name of a flawed economic model.