This is Gerald Silverberg's "Saving the Euro" web page. Last revised Jan. 24, 2011.

On Jan. 19, 2011, the International Herald Tribune published my op-ed piece One way to save the euro on page 7. The night before, even before agreement was reached to accept my original submission, I sent them a revised version that expanded on a number of important points. Then, to my surprise, I found out that they had already gone to press with the original version, so I am reproducing the revised version here, with permission from the International Herald Tribune.

Paul Krugman’s analysis of the euro crisis (IHT Jan. 14, “The triumph and tragedy of the euro”, also New York Times Global Magazine Jan. 12, "Can Europe Be Saved?") puts into perspective why the Eurozone countries now find themselves between a rock and a hard place. All of the policy alternatives he analyses seem to be highly unsatisfactory in one way or another. But this is very puzzling, because the Eurozone countries as a group were financially much healthier going into and even since the crisis than either the UK or the USA, both in terms of current and accumulated government debt. While the Eurozone also experienced a housing and consumption bubble and crash, what distinguishes the Eurozone from either of them was the fact that the bubble was confined to peripheral countries (Ireland, Spain and Portugal, Eastern Europe) while core Eurozone countries (particularly Germany, to a lesser extent the Netherlands, Belgium, France) exercised remarkable wage restraint, thus benefiting from export-led growth rather than domestic bubbles. The ILO recently estimated that the real-wage growth gap between the Euro periphery and Germany over the last ten years was over 20% (the nominal wage gap presumably being even higher).

With the normal escape route from this problem (national devaluation) closed to the Euro periphery countries as long as they remain within the Euro straightjacket, national austerity and wage deflation seem to be the only alternate that would restore competitive balance. But as Krugman rightly points out, they are self-defeating since they engender the destructive debt deflation (“cutting off the nose to spite the face”) Irving Fisher had analyzed during the last world economic crisis, and provoke social unrest.  However, creating a Eurozone transfer mechanism, rescue umbrella or even Eurobonds may only be a temporary palliative, since they may staunch the bleeding for a while but do not heal the underlying hemorrhage, i.e., the large disparity in wages and competitiveness between the peripheral and the core Eurozone countries.

Is the situation hopeless? Astonishingly, there is a very simple solution that squares the circle and leaves everyone happy, at least from a purely arithmetic point of view. Instead of furiously trying to drive nominal domestic wages down in peripheral countries, one could simply freeze them. Meanwhile, Germany and other core Eurozone countries could raise their wages by the amount necessary to restore competitive balance, while the Euro is devalued by a corresponding amount. The core countries would thereby retain their present unit labor costs (the basis of competitiveness) with respect to the rest of the world, while the Euro periphery would regain competitiveness both with respect to the Euro core and doubly so with respect to the rest of the world. Euro-denominated loans would not have to be restructured (with the possible exception of Greece, which was the only truly fiscally irresponsible member and should never have been admitted to the Eurozone in the first place), there would be no runs on banks, a competitive equilibrium, at least in the medium term, would be restored, and nervous financial markets could gleefully move on to the other elephants in the room, the US/China global imbalance, commodity prices, etc.

But is such a solution politically and institutionally feasible? Germany would go into it kicking and screaming, but since its competitiveness outside the Eurozone would be unchanged (aside from some higher import prices such as for oil), it would be infinitely preferable to the prospect of open-ended financial transfers it now quiveringly confronts to shore up the hemorrhaging Euro periphery and save its own banks that have lent heavily to it. Moreover, German workers, instead of being shorn twice—once from years of wage restraint and now by the prospect of higher taxes and cuts in social benefits to bail out their less “virtuous” European compatriots— would finally enjoy the fruits of long-overdue wage increases. Could the Euro really be devalued to guarantee this equilibrium outcome, while Europe’s competitors looked on passively? That would be the job of the ECB, a task the Chinese central bank seems to have mastered with bravura. Can Eurocore wages be raised at one fell swoop without triggering inflation? A good question. But ultimately it is the job of enlightened political leaders and central bankers to find ways to implement unconventional win-win solutions when the alternative, as Krugman convincingly argues, is an ongoing and, I would add, entirely avoidable fiasco for everyone.

So does this proposal rescue the Eurozone from the looming threat of unraveling and magically transform it into a sustainable currency zone? Unfortunately, the answer in the longer term is no. At best it can only be a ‘reset’ of the Euro that might grant it a lease on life for another ten years. Sooner or later a recession, the renewed accumulation of imbalances, or fiscal policy divergences would probably bring it to the brink again unless this reprieve were used by Eurozone member states to finally create the conditions of governance, which include but are not limited to a more extensive system of countercyclical financial transfers without creating false incentives, that make a currency union a viable proposition.

Gerald Silverberg
Senior Research Fellow, UNU-MERIT and IIASA

Readers may also be interested in my Global Financial Meltdown Page from 2009.

My blog on current events can now be found on my Meltdown Economics and Other Complex Catastrophes page.

(c) 2011 by Gerald Silverberg, all rights reserved.