Markets Insight
May 22, 2012 9:54 am
Devaluation – last option to save the euro
As debate about a Greek exit from the euro grows, the European crisis is reaching boiling point. There are three sources for the problems of Greece and other peripheral European nations.
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The first and most immediate is the fear that Greek banks will convert euro deposits into a new Greek currency. This has prompted withdrawals from not only Greek, but also Spanish and Portuguese banks and sent money flowing to German banks and German government bonds. The second is the unsustainable budget and current account deficits of many of the peripheral countries.
The third, and ultimately most important and intractable source of the crisis, is that labour costs in the peripheral countries are too high and uncompetitive with the northern European countries, particularly Germany. Historically, overpriced labour markets have been cured, albeit painfully, by currency devaluation – an option which is not open to euro-based economies.
If Greece does exit the euro and establish a new currency, investors fear that Greek deposits and Greek debt will be converted into a new currency which will sell at a steep discount to the euro. If Greece took this action, it would cause bank runs in Portugal, Spain, and even Italy as depositors fear their governments will do the same.
Although Greek and Portuguese banks are relatively small compared with those in the EU, banks in Spain and Italy are not. A run on the banks in those countries would need to be met by massive loans from the European Central Bank to prevent an all-out financial collapse.
That is why if Greece exits the euro and converts euro deposits into its own currency, it would be necessary for the ECB to quickly guarantee all deposits in all eurozone banks, a policy similar to the one that the Federal Reserve followed after the Lehman bankruptcy in 2008.
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The second source of the crisis involves the large and growing debt of the peripheral countries. This has led to ECB and German demands for austerity which have sparked a fierce backlash in Greece and other countries. But excessive government debt is not now the most critical problem facing the peripheral countries.
The US, the UK, and Japan have huge budget deficits yet their banking systems are stable and their interest rates are at or near record lows. Even if the peripheral countries slash spending and raise taxes to reach a sustainable debt path, they will still remain in severe recession because of the uncompetitive state of their labour markets.
The source of their labour market problems is not difficult to find. When, following the adoption of the common currency, risk spreads between Greek and German debt fell, capital quickly flowed into these peripheral countries. This generated a boom that raised labour costs beyond productivity growth, primarily because unions found it easy to compare their wages to workers in Germany and the strong economic conditions encouraged acquiescence to labour demands. When the financial crisis hit, labour costs had risen too high and unemployment skyrocketed.
Austerity does nothing to solve the problems of an uncompetitive labour market. Reforming the tax systems of Greece, Spain and other peripheral countries and reducing their bloated public sectors and unsustainable pension systems are important long-term goals. But raising taxes and cutting spending now will only worsen their recessions.
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Some economists have argued that the peripheral countries implement “internal devaluation”, the reduction in nominal wages to regain labour competitiveness. But history has shown that the substantial reduction in nominal wages necessary to achieve this goal would be extremely difficult to achieve and apt to worsen their current downtrends.
The least disruptive route Europe can take is to sharply lower the value of the euro. This will help improve the trade deficit in the peripheral countries and bring some relief to their downward spiralling economies. Euro depreciation would push the German trade surplus even higher and cause some inflationary pressures in those few European countries that are still near full employment. Given the strong German labour market, a lower euro would be likely to raise German wages and help close the gap between German and other European labour costs. The mild inflationary effect of a euro closer to dollar parity would be far less painful for all concerned than forcing austerity or internal devaluation on the peripheral countries.
The European Monetary Union was a high-minded, but ill-conceived plan to spur economic growth and forge a closer political union among European countries. The current pressures by the German government to force austerity on the peripheral countries will accelerate the disintegration of the monetary union. The ECB’s best hope of saving the union is to back away from austerity and accept a lower euro. It may not work, but it is the last viable option to save the common currency.
Jeremy Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania
Copyright The Financial Times Limited 2012.
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