A popular narrative has unfolded around Europe's sovereign debt crisis. It revolves around extravagance in Europe's periphery and the need for Europe's more responsible countries to deal with the repercussions of excessive debt. It applauds efforts to discipline certain countries in order to guard against a recurrence of less-than-prudent fiscal and financial behavior. Though this popular story carries much truth, Europe actually has more fundamental problems.

The euro could never have delivered on the benefits promised to smaller, poorer economies. The different rates at which nations joined the common currency did much to create today's problems.

Even worse, the inflexibility implicit in the common currency will create more pain in Europe than is commonly expected to rectify the Eurozone's very fundamental problems.

The surface facts of Europe's sad situation are by now familiar. Greece, Ireland, Italy, Portugal and Spain have become so mired in debt that they have threatened default. Greece and Ireland have received aid from the European Union with conditions that effectively dictated their economic and financial policy and infringed on their sovereignty.

The standard story used to explain these events is almost as familiar as the facts. It holds that indulgent policies and a lack of foresight in these peripheral nations led to an excessive use of debt that now threatens their financial viability and by extension the viability of the common currency and the EU. The tale goes on to say that now more responsible, thrifty, and hardworking countries, particularly Germany, must protect European finances and the European Union by lending to these irresponsible member states while guiding their policies along more prudent paths.

Irritating as the moralizing tone of these explanations is, it must be conceded that Greece, Ireland, and these other nations did indeed spend more than Germany relative to their resources. And now, if the EU and the euro are to avoid grievous harm, Germany and other more fiscally sound members of the Union have to take action.

But in their rush to condemn, EU officials seem to have forgotten how-when gathering nations to join the euro-they encouraged the borrowing that they now deplore. They told the smaller, weaker nations that the euro would enable them to borrow more easily and cheaply than they could in their own currencies by offering lenders a more liquid and stable investment. They argued that these lower rates would relieve strain on national finances and encourage quicker development by increasing the flow of credit.

The argument recurred as each nation considered joining. In 2007, when Iceland faced its decision, a major domestic advocate, the Kaupthing Bank, noted pointedly how the common currency's relative stability would reduce the cost of credit.

Euro advocates in the UK also made the low interest rate argument.

In fact, the notion of lower interest rates ranked second on the Liberal Democratic Party's 12 reasons for joining the euro. Remarkably, even Estonia, joining the euro in the midst of the sovereign debt crisis, noted cheaper financing costs as a benefit. And for a while, reality seemed to back up those claims. Greece, after it joined the euro, could borrow at rates of half a percentage point to a full percentage point higher than Germany paid, a considerable reduction from spreads of 2.5 to 3.5 percentage points or more over Germany when Greece borrowed in its old national currency-the Greek drachma. Ireland, Italy, Portugal and Spain could make similar comparisons.

But a big part of the argument constituted a deception, willful or not. Though the currency in which debt is denominated does affect rates, the relative cost of borrowing has more to do with the creditworthiness of the borrower, as is now painfully clear.

But the erroneous low-rate mentality helped erode this critically important credit consideration by encouraging Europe's weaker, poorer, countries to borrow and spend more than they otherwise would have. Now the EU's leadership has not only abandoned the old arguments about active borrowing, it has repudiated them, leaving questions about how many of these weaker economies would have joined the euro in the first place had they realized the limits of this benefit.

Of still greater fundamental significance in creating today's mess are the imbalances built into the euro from the start. Greece, Ireland, Italy, Portugal and Spain were allowed to exchange their domestic currencies into euros at higher rates than their economic fundamentals of productivity and profitability could justify. But Germany made the exchange at a much lower rate than its economic fundamentals needed. In its most direct impact, the low rate of Germany's exchange made its products more attractively priced than the products of the periphery nations.

Moreover, the low rate of Germany's entry also understated German incomes in Europe, creating a feeling of austerity that encouraged saving and wage restraint.

Meanwhile, the high rates at which the periphery entered inflated their populations' buying power in euros, creating a false sense of wealth. And that encouraged more borrowing and created an easy attitude toward wage increases and pension benefits.

Precision in measuring such differences is always problematic. Fortunately, the International Monetary Fund offers a gauge. It regularly calculates the difference between existing exchange rates and the rate that would equalize the costs of tradable goods in different countries.

Economists call this purchasing power parity. When an exchange rate rises above purchasing power parity, the country's consumers command an artificially high buying power and the economy's tradable goods become more expensive than elsewhere. When the exchange rate falls below the purchasing power parity, the opposite is true.

The IMF data shows that Greece, Spain, and Ireland made their conversion to the euro some 6% higher than Germany did.

So right from the start, the common currency set up Germany as Europe's producer and exporter while making the continent's periphery its natural customer. Once this stage was set, matters only went downhill.

Because the situation encouraged exports, wage restraint, and savings in Germany, the country tended to improve its competitiveness over the years. And that rendered the original rate which Germany joined at still more advantageous to German exports.

In contrast, the lack of savings in Europe's periphery and its dependence on imports induced these nations to neglect the production side of their economies, causing further deterioration in their competitiveness. Consequently, that made the original high rate at which they joined the euro even less realistic.

By 2009, the IMF figures show that Greece's pricing relative to purchasing power parity had deteriorated to 12% above Germany's. Spain's was more than 20%, and Ireland's 32%.

Other factors were also at work. Germany faced much more direct pressure from Eastern and Central Europe than the other countries. And that imposed an economic discipline.

No doubt, pre-existing industrial infrastructures, or the lack thereof, factored into the equation as well. Cultural differences are undeniable, though much popular commentary has shamelessly exaggerated these into crass national stereotypes.

If these countries had separate currencies, as they once did even inside the European Union, they would have a reasonably straightforward way out of today's problems. Market pressures would devalue or adjust currencies as the economic fundamentals dictated, and so erase the exchange imbalances that have distorted economic interactions and contributed to this crisis.

A devaluation of the Greek drachma against the German deutschemark, for instance, would lower the prices of Greek exports and raise those of the German competition. Consequently, Germans would buy less at home and more from Greece, while Greeks would buy more at home and less from Germany. By making German incomes more valuable on the European stage, the deutschemark revaluation would create a feeling of wealth that would raise German inclinations to borrow and spend. A devaluation of the drachma would have the opposite effect on Greek income, inducing people there to borrow less and save more.

In other words, the patterns that have created the crisis would go in reverse and restore a better balance.

But within the single currency, such adjustments are impossible.

The only solution, then, apart from dissolution of the euro, is a long, painful adjustment in the economic fundamentals of Europe's periphery.

The Greeks, Irish, Italians, Portuguese, and Spaniards will have to restrain their economies long enough to create outright deflation, as Ireland is already suffering. They at least need to hold inflation rates below those in Germany and other stronger economies in the Union.

In time, and sadly with a great deal of unemployment and wealth destruction, such changes would achieve the same effect as revaluations and devaluations. Lower prices in the periphery than in Germany would help restore export-import balances. The poorer nations would spend and borrow less and work harder, while relatively richer Germans would have the opposite impulse, at least at the margin.

This need for an extended period of economic restraint and hardship in these weaker economies is an ugly prospect. But if the euro is to survive, this is the only route to correct the fundamental imbalances and prevent a recurrence of the problems.


Milton Ezrati is Partner and Senior Economist and Market Strategist at Lord Abbett and is an Affiliate of the Center on Human Capital and Economic Growth in the Department of Economics at the State University of New York at Buffalo.

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