Nicolas Sarkozy knows how to spice things up – his comment that it was a “mistake” to let Greece into the Eurozone has ignited much commentary, mostly in support for his statement. And yet that’s a silly thing to say – and it is also an unhelpful thing to say because it focuses attention on the euro as the chief problem, when it is not.
First things first: today’s crisis would not be alleviated if Greece exited the Eurozone. Europe’s problem is that banks hold Greek debt – whether that debt is denominated in euros, drachmas, gold or goats makes no difference. Think about the United States bailing out Mexico in 1994 – the problem is exposure, not the currency in which that exposure is denominated. Second, throwing Greece out of the Eurozone would trigger a massive banking crisis elsewhere. Spanish, Irish, Italian, and Portuguese depositors would wonder whether their euros will overnight turn into pesetas, pounds, liras or escudos. They will move their money abroad. Their banks will face imminent collapse. Third, would a devalued currency help Greek exports? Yes. But it would do by merely offering a lower price, when instead, Greece needs better products not bad products at a lower price. And fourth, there is of course a political dimension - the period to prepare for entry into the Eurozone, for instance, was also the period when public finances were at their healthiest.
So much for the present – what about history? To what extent is the current crisis to blame on the euro? In one way, it is hard to blame the euro. The debt problem emerged from the fact that the European periphery was able to borrow at interest rates that were too low relative to their fiscal health. The euro is to blame in a round-about way - although bailouts for fellow Eurozone members were prohibited by the Monetary Union, the markets treated all European debt equally – Greece and Spain were the same as France and Germany. The convergence in bond yields was the result of that treatment.
This was a view that the market is regretting these days – and yet, the market may not be altogether wrong. Germany is indeed stepping in to guarantee some of that debt – and in a slightly better scenario, investors in Greek debt would have seen no haircut at all courtesy of the German taxpayer. So the problem came not from the adoption of the common currency but the widespread assumption (legally wrong but, in retrospect, politically right) that European countries would step in to support each other’s debt. And much of the crisis now emerges from the uncertainty about exactly how much debt Germany and other countries will really shoulder. Again, nothing to do with currencies.
So much for debt – what about the broader question? The guiding principle here is an economic theory about “optimal currency areas,” which lays out characteristics that entities must share in order to form an “optimal currency union.” The two key ideas are: (a) countries in a monetary union may end up with monetary policies that are too expansionary or restrictive, either fueling a bubble (if money is too cheap) or slowing down growth (if money is too dear); and (b) with a fixed exchange rate, countries lose currency appreciation or depreciation as a way to correct imbalances.
There is, in fact, evidence for both propositions. Greece’s inflation rate was above the Eurozone average, and so the interest rate set for the Eurozone was too low for Greece. So people and companies over-borrowed. And there is no also no doubt that with no ability to devalue its currency, Greek exports suffered. Neither of these two statements can be denied. But these points take you only so far; they don’t answer the crucial questions: did membership in the Eurozone push the country to crisis? And second, what would have life looked like outside the Eurozone?
Cheap money fuels borrowing and Greece’s above average inflation fueled borrowing. But Greece’s debt problem is public, not private – and while cheap money can raise private borrowing, public borrowing is determined by the appetite that markets have to lend to a sovereign. And there the problem was not membership in the euro but, as I said above, the presumption that this membership entitled Greece (and others) to interest rates that were almost identical to Germany.
At the same time, Greece benefited from the euro with lower inflation and exchange rate stability. More generally, the argument against the currency union betrays the economics profession’s love with monetary policy, trusting that that no matter what the problem monetary policy can solve it. Guess what? It can’t and it hasn't. For example, monetary policy was flawed in the early 2000s in the United States. So yes, Greece gave up the right to conduct monetary policy but there is no guarantee that it would have exercised that right much better than what the ECB did – it would likely have ended up with more inflation and little else.
A second way to look at this question is to distinguish between inflation as a monetary or a micro-economic phenomenon. Monetarists such as Milton Friedman say that, “inflation is always and everywhere a monetary phenomenon.” The problem is with “always” in that sentence since inflation also has micro-economic roots from the lack of competition in product markets and services and in wage-setting practices. In the case of Greece, in particular, inflation was very much rooted in entrenched and quasi-monopolistic structures as well as in strong unions that allowed for wages to be set without due regard to productivity.
Why does this matter? Because it takes us to the adjustment issue – with a fixed exchange rate, overvaluation is “internal” which means prices start getting out of sync with underlying productivity trends. But allowing the price to fall is, in a way, the wrong way to correct this problem – you are saying that you are changing too much for something and you should lower the price. By competing on price, you end up not competing on other things such as quality. It also does nothing to correct these micro-economic distortions such as monopoly or improper wage-setting practices – by merely altering the price, you preserve these practices.
So if you put all these things together, you get the following: (a) excessive borrowing driven by a perception about sovereign risk that was linked but not necessarily connected to membership in the Eurozone; (b) monetary policy under a Greek government is unlikely to have been that much better; and (c) successive devaluations would have done little to correct the underlying problems that produced higher inflation and lack of competitiveness. Plus solving the crisis has little to do with Greek membership in the Eurozone and everything to do with who holds Greek debt. That’s why the question of whether Greece should have entered the Eurozone and whether it should stay in it is more of a distraction.