Friday, October 15, 2010

Cancel the Obituaries for the Euro

When Greece faced a serious financial crisis in 2010, many Euro-sceptics rubbed their hands in glee and wrote obituaries for the currency union. It now looks as if these obituaries have been premature. The Greek government adopted policies that are returning the country to economic stability. Domestic protests against these policies appear to have run their course.

The value of the Euro reflects the confidence the worlds’ investors have in the currency. While it was worth 1.51 US dollars before the crisis in December 2009 and had fallen to 1.19 at the height of the crisis in June 2010, it has since then climbed steadily and reached 1.40 in the middle of October.

The writers of the obituaries for the Euro based their views on the premise that the people of countries like Greece would suffer unnecessarily because its government could no longer use monetary, exchange rate and fiscal policies to deal with unemployment and other economic calamities. In response to these sufferings, they would flee the yoke of the Euro, adopt their own currencies and quickly eliminate these problems.

The main reason why the Euro-sceptics were wrong is that the problems of Greece and other countries like Italy and Spain have not been caused by the traditional business cycles and economic shocks. They have been caused by persistent economic mismanagement rooted in social-democratic ideology, which cannot be cured by Keynesian monetary and fiscal policies but require external pressures on politicians to mend their ways.

The driving force behind Greece’s economic mismanagement during the postwar years has been a belief in the idea that governments can do better than free markets and create a socialist utopia. It resulted in many unsustainable policies. One of these was that the government protected workers and firms from the impact of shifts in international comparative advantage. When Greek shipyards and the producers of textiles could no longer compete with foreign producers, the government bought the firms in trouble. It kept most of the workers or induced them into early retirement.

At the same time, Greece expanded public sector employment to deal with high levels of unemployment, which to a large extent were caused by its own misguided industrial policies. It used economic and financial regulation intensively to advance its ideological goals. It used tax and social spending policies to offer security from cradle to grave and equalize incomes.

The consequences of these policies were unavoidable. They resulted in large fiscal deficits due to bloated public sector employment and the fiscally irresponsible operation of public enterprises; low average retirement age for Greek workers; high levels of corruption and tax evasion; and most important for the longer run, slow productivity growth.

While most of these consequences worked slowly and were hidden from public scrutiny, the fiscal deficits were not. To finance them, Greek governments forced the Greek Central Bank into buying its bonds and paying for them by printing money. As a result, between 1971 and 1994 inflation averaged 17.7 percent annually. The inflation in turn caused the value of the drachma to fall to about 10 percent of its initial trade weighted average value between 1964 and 1999.

When Greece adopted the Euro in 1999, the inflationary financing of deficits through its central bank ended because the central bank lost its ability to print money. For some years, inexplicably, private sector investors continued to buy Greek bonds without asking for risk premiums commensurate with the unsustainable growth in the public debt. However, the global financial and economic crisis that started in 2008 changed all that. There were predictions that Greece would be unable to sell its bonds and declare bankruptcy.

That was the time when Euro sceptics had their day and the currency was under attack. But instead of resulting in a crumbling of the Euro, the attack produced international commitments to buy Greek bonds under the condition that the government adopt policies that would restore fiscal balance and modify the social democratic policies discussed above.

The beneficiaries of government programs demonstrated and rioted against the implementation of changes that would damage their interests. However, the Greek government had no choice but to make the needed changes and resisted their blandishments. Chances are that politicians welcomed the external pressures for policy changes that they knew were needed but which under normal conditions would have guaranteed electoral defeat. Doing so is perfectly consistent with publicly blaming outside forces for the problems suffered by interest groups.

There is no doubt that the newly adopted policies will benefit all Greeks. The ability to run fiscal deficits will be constrained more than ever before. The resources spent in the past by interest groups lobbying the government for more benefits and regulation will go into productive efforts in the private sector. Inflation will continue to be limited to rates in the rest of Europe.

The Euro system has proven sceptics wrong. Criteria for membership in an optimum currency have turned out to have been endogenous, just as some academics had predicted.

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