The first two components of the euro crisis — a banking crisis that resulted from excessive leverage in both the public and private sectors, followed by a sharp fall in confidence in eurozone governments — have been addressed successfully, or at least partly so. However, that leaves the third, longest-term and most dangerous factor underlying the crisis: the structural imbalance between the eurozone’s north and south.
First, the good news: The fear that Europe’s banks could collapse, with panicked investors’ flight to safety producing a European Great Depression, now seems to have passed. Likewise, the fear, fueled entirely by the EU’s dysfunctional politics, that eurozone governments might default — thereby causing the same dire consequences — has begun to dissipate.
Whether Europe would avoid a deep depression hinged on whether it dealt properly with these two aspects of the crisis. However, whether Europe as a whole avoids lost decades of economic growth still hangs in the balance, and depends on whether southern European governments can rapidly restore competitiveness.
The process by which southern Europe became uncompetitive in the first place was driven by market price signals — by the incentives those signals created for entrepreneurs and by how entrepreneurs’ individually rational responses played out in macroeconomic terms. Northern Europeans with money to invest were willing to lend on extraordinarily easy terms to those in the south who wanted to spend, and ample pre-2007 spending made employers there willing to raise wages rapidly.
As a result, southern Europe adopted an economic configuration in which its wage, price and productivity levels made sense only so long as it spent 13 euros (US$16.78) for every 12 euros that it earned, with northern Europe financing the missing euro. Northern Europe, meanwhile, adopted wage and productivity levels that made sense only as long as it spent less than one euro for every euro that it earned.
Now, if, as appears to be the case, Europe does not want its south to spend more than it earns and its north to spend less, wages, prices and productivity must shift. If we are not to look back in a generation and bemoan “lost” decades, southern European productivity levels need to rise relative to the north, and wage and price levels need to fall by roughly 30 percent, so that the south can pay its way with exports and northern Europe can spend its earnings on those products.
If the euro is to be preserved and if stagnation is to be avoided, five policy measures could be attempted:
‧ Northern Europe could tolerate higher inflation — an extra two percentage points for five years would take care of one-third of the total north-south adjustment;
‧ Northern Europe could expand social democracy by making its welfare states more lavish;
‧ Southern Europe could shrink its taxes and social services substantially;
‧ Southern Europe could reconfigure its enterprises to become engines of productivity;
‧ Southern Europe could enforce deflation.
The fifth option is perhaps the least wise, for it implies the lost decades and EU collapse that Europe is trying to avoid. The fourth option would be wonderful; but, if anyone knew how to bring southern Europe’s enterprises up to the productivity levels of the north, it would have happened already.