The Washington PostDemocracy Dies in Darkness

The four ways to end the Greek crisis, from Obama’s former top economist

A European Union flag, left, hangs beside a Greek national flag beneath the Parthenon temple on Acropolis hill in Athens, Greece, on Tuesday, May 1, 2012. It is "entirely possible" IMF, EU will refuse to make next payment to Greece if new govt doesn't fulfill its commitments, UBS's Stephane Deo says in note to clients before May 6 elections. Photographer: Simon Dawson/Bloomberg

It wasn't that long ago that Austan Goolsbee worked in the White House, as President Obama's top economist, and a financial crisis in Greece was threatening the global economy. Now Goolsbee is back teaching at the University of Chicago, Obama is halfway through his second term ... and Greece is rearing up again.

We shouldn't be surprised, Goolsbee says, because Greece and its fellow Eurozone nations are trapped in a cycle of differential shocks -- which is to say, they're seeing what happens when different parts of a unified currency area experience vastly different economic events. Greece is mired in recession, with low productivity growth, while countries such as Germany are seeing their economies expanding and productivity rising at a faster clip. If Greece had its own currency, it would weaken against its neighbors until growth and productivity sputtered back to life.

As it is, Goolsbee said in a phone interview Monday, there are only four ways to break the cycle while keeping Greeze in the Euro - and it's not clear European leaders are willing to see any of them through.

“It’s not inevitable that everything blow up in a flaming mess," he said. "It’s just that, if it doesn’t blow up in a flaming mess, it’s going to go on in a very recognizable pattern.” The rest of the interview is edited for length.

How should economic policymakers - the Fed, the U.S. government, Europeans - respond to Greece now?

“As I look at it, I think there’s only four things that you can ever do when you get differential shocks. You can have labor mobility. You can have permanent subsidies. Those are the two things that we have in the U.S., and that’s why nobody ever asked after Hurricane Katrina, is Louisiana or Mississippi going to drop out of the dollar? And that’s because, there’s mobility and there’s a fiscal union where they get a big subsidy.

“So you could have one of those two, or you could have Germany willing to do four or five percent inflation for a couple of years, to do the equivalent of an exchange rate channel. Or else you could have Greece try to grind down its wages and find some way to get its productivity growth rate faster than Germany’s. That’s it! Those are the only four things you can do.

Which one should they pick?

"The East German unification with West Germany had a similar feature. East Germany came in (to a unified Germany) at an overvalued exchange rate. They made that decision on political grounds, not economic. So overnight they went to having basically West German level wages with Polish productivity.

“There was a trillion euros of subsidy, there was a massive amount of labor mobility, there was a national commitment to make it all work. And that said, it’s still the case that unemployment rates are higher in East German locations than the former West German ones. Which I think tells you that you should never make light of the difficulties of what they call internal rebalancing.

"(In the Eurozone) you’ve got low mobility, and you’ve got low subsidies. Northern Europe does not appear to me to be willing to run four or five percent inflation for a time while Greece runs zero, and therefore, you’re only left with, try to grind down the wages in Greece or find some other way to increase productivity.

“If you look at the Greek economic record, it’s been very similar to the U.S. experience in the first four years of the Great Depression. And after having a Depression-sized event, they’ve cut the unit-labor cost in Greece – they’ve closed something like half the gap with Germany. The question is, do you think it’s realistic, that Greece only needs to have a second Great Depression and then they’ll be able to equalize the imbalances?

“Either places like Germany are going to decide it’s too important to hold this thing together, and they’re going to find some non-public way to subsidize it permanently, or else we are going to have a crisis every six months, over and over again, until somebody says we can’t take it anymore. There’s no way that they can turn things around in anything like the timeframe of what the creditors are demanding.

How will that play out?

"There’s a group of people who think that this is fundamentally a Greek problem. It’s Greece’s fault. Now you’ve started to see that group say publicly, 'good riddance'. Greece is going to get kicked out or Greece is going to default or something, good riddance. If you can get Greece out of there, that solves the problems.

"I think that’s not right. (If Greece leaves) somebody else will be in the same situation within a couple of years. They’re having differential shocks. Eventually Portugal or Italy or somebody is going to get back into a very similar situation as Greece.

“The critical question is going to be, how does Greece do if it drops out? If Greece re-establishes separate currency and basically, two years from now, has devalued, is growing again and is doing ok, then I think the lesson to the rest of the Eurozone might be very different from what it appears to be now.

"Right now, one gets the sense that the governments of the creditor nations want this to be as painful as it can be for the Greeks, so that no one else is tempted to do this. They want it to be bad. They might be able to make it bad. But there is certainly a chance that two years from now, it’s not actually that bad.”