Leaving the euro behind?

By Sebastian Mallaby
Friday, April 30, 2010

Two months ago, his back against the wall, the finance minister of Greece chose a strangely honest metaphor to describe his country's prospects: "We are basically trying to change the course of the Titanic." Since that remark, this modern Greek tragedy has played out much as its anti-hero prophesied: Investors understand that Greece has borrowed more than it is likely to repay, so they have driven up interest rates on Greek bonds, setting off a death spiral. At moments, the tragedy has been tinged with farce. After the government promised to collect more tax revenue and keep paying its debts, Greek civil servants went on strike -- including some tax collectors.

Now the question is how many other European countries might follow Greece -- and what this means for Europe's common currency. The beginnings of the same death spiral threaten the indebted economies of Portugal and Spain; Italy and Ireland also look vulnerable. Europe's leaders have dithered disastrously about whether they would provide Greece (and, by extension, others) with a bailout. Even if they belatedly come forward with a large rescue, the crisis has exposed alarming flaws in Europe's currency framework.

The euro project can work only if its members are improbably virtuous. This is often thought to mean simply that governments must avoid borrowing too much: Countries that use the euro are supposed to keep budget deficits below 3 percent of gross domestic product -- not that they have done that. But the crisis has spotlighted a second temptation: Countries in the eurozone must prevent private companies from raising workers' pay too fast. Otherwise they can't compete against the cost-containing Germans.

Of these two temptations -- too much borrowing and too much pay -- the first is getting all the attention, but the second is most threatening to the euro. After all, a government that borrows too much can simply default. It can do that whether it is inside a currency union or outside it.

But a eurozone member that allows wages to rise unsustainably has no such easy exit. It cannot regain its competitiveness by the usual trick of devaluing its currency because it no longer has its own currency. It therefore must compete by pushing wages down, an extraordinarily unpopular recourse that is unlikely to succeed in a democracy. Offered a choice between this root-canal austerity and quitting the euro, there is little doubt about which option most voters would go for.

Moreover, even if workers could be persuaded to accept wage cuts, the medicine could well fail anyway. Uncompetitive countries run trade deficits: They buy more from other nations than they sell and pay for the difference by borrowing from foreigners. Now, what happens when an indebted country tries to become competitive by forcing wages down? Falling wages means deflation, and deflation increases the burden of those debts -- if you owe a bundle on your credit card and your wages take a sudden hit, you will struggle to make your next payment. Because of this debt-deflation pincer, uncompetitive and indebted countries must choose between default and leaving the euro.

Greece -- the poster child for the high-debt, high-wage trap -- will stay in only if it is bribed to do so. Its neighbors will have to assume the burden of Greek debts if they want to paper over the cracks in the euro project. Yet while Europe, with International Monetary Fund assistance, has the money to rescue tiny Greece, it would be hard put to prop up a bigger economy such as Spain. Just as U.S. authorities saved a small investment bank (Bear Stearns) but balked at saving a bigger one (Lehman Brothers), so the Europeans may rescue Greece in the name of the system and yet see the system collapse anyway.

The Bear Stearns comparison contains a further lesson. The bailout of Bear lulled investors into complacency: Some felt they needn't prepare for the collapse of other banks because the government would stop the worst from happening. But the moral hazard created by a Greek bailout would be far more dangerous. At least the U.S. government can fight the effects of moral hazard by regulating risk-taking at banks. European institutions can't discipline their member states -- witness the fact that nearly all violated the 3 percent limit on their budget deficits.

The eurozone's twin temptations -- to borrow too much, to raise wages too much -- always threatened the cohesion of the currency union. But if Greece is rescued from its follies, the temptations will become stronger. Bailed-out investors will be reinforced in their convictions that they can lend freely to big spenders, so the spending will go on. Eventually some profligate member country will prove too big to bail, and the euro edifice will topple.

The hard truth is that Europe may have to choose between a small crack in the euro project now or a bigger one later. By bailing out Greece, it may be choosing the wrong option.


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