The Failure of the Euro

If Greece were not part of the eurozone, its exchange rate would adjust over time to prevent this large and growing trade deficit. More specifically, the need to finance that trade deficit would cause the value of the Greek currency to decline, making Greek exports more attractive to foreign buyers and encouraging Greek consumers to substitute Greek goods and services for imports. The rising cost of imports would also reduce real personal incomes in Greece, leading to lower consumer spending and freeing up Greek goods and services to be exported to foreign buyers.

But since Greece is part of the eurozone, this automatic adjustment mechanism is missing. Greece faces the persistent problem of a rising current account deficit, which has now reached ten percent of GDP, because Greece's productivity (output per employee) increases more slowly than Germany's, causing the prices of Greek goods to rise relative to the prices of German and other European goods. More specifically, if output per employee in Germany increases by three percent a year, real wages can also grow by three percent. If the ECB keeps inflation in the eurozone at about two percent, German wages can rise by five percent a year. If Greek wages also rise by five percent a year while productivity in Greece grows by only one percent a year, the prices of Greek goods and services will increase two percent faster than the prices of German products. That increase in the relative prices of goods and services would cause Greek imports to rise and exports to stagnate, creating an increasingly large trade deficit. This problem could be avoided if the annual rise in Greek wages were limited to two percent less than the rise in German wages. This may, of course, be politically difficult in the highly unionized Greek economy.

But limiting the growth of Greek wages would address only further deterioration of Greek competitiveness in the future. Stopping a further decline in Greek competitiveness would not correct the existing annual current account deficit of nearly ten percent of GDP that Greece must continue to finance. Eliminating the existing current account deficit would require making Greek prices much more competitive than they are today, by reducing the cost of producing Greek goods and services by about 40 percent relative to the cost of producing goods and services in the rest of the eurozone. Since that is not likely to be achieved by increased productivity, it must be achieved by lowering real wages relative to the real wages of Germany and other countries in the eurozone. This would be a very painful process, achieved at the cost of years of high unemployment and declining incomes. Greece now has an official unemployment rate of 16 percent, and its real GDP is falling by seven percent per year. Continuing such poor performance for a decade or more is virtually unthinkable in a democracy. Moreover, since such a process would shrink the current account deficit only over a long period of time, Greece would need to continue borrowing to finance its current account imbalance. Even if Germany were willing to formalize such long-term financial assistance by establishing a transfer union to provide those funds, the controls that Berlin would demand to keep wages and incomes declining would create severe political tensions between Germany and Greece.

via www.foreignaffairs.com