Greece fire (is that what we're calling it now?)

Europe's attempts to stem the Greek debt crisis haven't calmed interbank lending markets. The TED spread (LIBOR minus Treasury bill rate) has poked up above 30 - well below the crisis levels of 2008-09, but troubling nevertheless.

The NY Times assesses the danger this poses for the European and US banking systems. But the article's focus on the dangers of public debt is misguided:

The European rescue plan, totaling 750 billion euros, is intended to head off the risk of default but would vastly increase borrowing. That could hamstring Europe’s nascent recovery.

Indeed, it was too much debt that caused the problem in the first place: a new report by the International Monetary Fund warns that “high levels of public indebtedness could weigh on economic growth for years.”

The world’s budget deficit as a percentage of gross domestic product now stands at 6 percent, up from just 0.3 percent before the financial crisis. If public debt is not lowered back to precrisis levels, the I.M.F. report said, growth in advanced economies could decline by half a percentage point annually...

After borrowing trillions to stimulate their economies and ease credit concerns during the last wave of fear in late 2008 and early 2009, governments cannot borrow trillions more without risking higher inflation and shoving aside other borrowers like individuals and companies. Short-term interest rates, already near zero in the United States, cannot be lowered any further. And vital steps like raising taxes or cutting spending increases could snuff out the beginnings of a recovery in northern Europe and worsen the pain in recession-battered economies like Spain, where unemployment recently passed 20 percent.

With the exception of wartime, “the public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution,” Willem Buiter, Citigroup’s top economist, wrote in a recent report.

“Restoring fiscal balance will be a drag on growth for years to come.”

Though excessive public debt in Greece and possibly Portugal, Spain, and some other countries, is clearly the root cause of the problem, the high levels of debt in the US, Germany, France, UK and other large economies have little to do with it. As Paul Krugman notes, according to the IMF report cited in the article the reason debt has exploded in these countries is a decline in tax revenues due to the recession, not excessive government spending. (The report also makes the specious claim that the financial crisis has caused a permanent reduction in potential GDP.) Attacking deficits now would be the height of insanity: we need continued fiscal stimulus to maintain the recovery and put us in a position where we can begin to restore fiscal balance in a few years.

Near term, the ECB needs to learn a lesson from the Federal Reserve's success in the US and begin a program of quantitative easing focused on purchases of sovereign debt. Fears that this would be wildly inflationary are crazy - at any rate, Europe could use a dose of higher than normal inflation at this point in time to ease the adjustment of countries like Greece.

A way out for Greece

Mark Weisbrot says the only solution for Greece's economic and financial woes is to leave the Euro zone. Paul Krugman applauds Weisbrot for the sentiment but argues that in doing so Greece would give up numerous benefits from being a member of the Eurozone such as access to cohesion funds from the rest of Europe and the "hard to quantify but probably important things like the stabilizing effect, economically and politically, of being part of a grand democratic alliance." Is there an alternative? I think so.

First, a recap of Greece's problems. Greece has an excessively large government sector and byzantine system of commercial and labor market regulation that retards the efficient allocation of resources and investment. It needs structural reform. Greece has a high internal price level that makes its goods uncompetitive in the rest of Europe. It needs a devaluation, but it can't as long as it's in the Euro system. The alternative to devaluation is "internal devaluation," i.e. a recession big enough to push down prices and wages so that the economy is competitive once again. No one wants that. Greece has a monstrous foreign debt that it is unlikely every to be able to repay. It needs significant debt relief. But foreign lenders don't want to offer the relief, especially if Greece is going to continue to manage (if that's the right word for it) its economy as it has in the past.

Ok, so how about this. Greece stays in the Euro system and retains all the benefits thereof. The Greek government implements a law mandating a uniform reduction in prices and wages by, say, a third, or whatever amount is necessary to regain international competitiveness, followed by a temporary price freeze. This stimulates the economy, which improves the government's fiscal situation and gives it breathing room to implement some much needed product and labor market reforms. To reward Greece for these efforts (in an explicit quid pro quo - this won't work otherwise) Greece's creditors forgive a large portion of Greece's foreign debt (as much as a third, or the amount of internal devaluation Greece is implementing). Voila, we have a more flexible, competitive, and most importantly growing economy, still a member of the Euro zone, working through its remaining debt problems.

Crazy? Quite possibly. But there's plenty of historical precedent for price controls during times of economic crisis. Price controls worked well in the US during World War II, not so well in 1971-73. They've also worked with mixed success as part of Brazil's and Argentina's stabilization programs in the 1980s. Price controls have typically occurred in an inflationary environment. When they haven't worked it's tended to be because the monetary authorities continued to expand rather than contract, resulting in suppressed inflation that burst out when controls were lifted. This is a different environment - the problem is deflation rather than inflation, and monetary policy is in the hands of the ECB rather than the Greek government.

Furthermore, all of the other possibilities seem worse. Desperate times call for desperate measures.

Bring on the coolies!

The Greek crisis poses an incredible challenge to Europe and could pose a threat to the US recovery. I think Paul Krugman has it right: even if Greece defaults, the magnitude of the fiscal adjustment it will have to endure is greater than is consistent with its membership in the euro system. The problem is that reducing its deficit will be extraordinarily contractionary. Its participation in the euro system does not allow it to soften the blow with a monetary expansion or devaluation of the currency. Europe does not have the type of interstate fiscal transfers that would cushion the economy in the US.

Greg Mankiw calls Krugman's argument "thoughtful and thought-provoking." Mankiw then offers some of his own thoughts, which I can only describe as "head-scratching and mind-numbing." Referring to the fiscal transfer issue, Mankiw writes

Is that right? I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine...

One might argue that the 19th century had a different set of labor institutions than we have today, and these facilitated the adjustment of wages. That argument, suggested by the research of Chris Hanes, may have some merit. If that is the case, then maybe that is the path forward for Greece and the rest of Europe. As Paul suggests, increasing wage flexibility won't be painless. Yet it might be easier than giving up on the Euro experiment.

The snarky response is to remind N. Greg that 19th century America's labor market institutions included slavery, coolie and child labor, and a host of other abominations. Setting the snark aside though, the problem with Mankiw's argument is that the political system in the US, not to mention Europe, would not, cannot tolerate the type of volatility, hardship and dislocation that the 19th century business cycle entailed. Current US fiscal institutions developed, by design or by chance, at precisely the moment at which US political institutions ceased to be tolerant of the unfettered 19th century business cycle and government took on a greater responsibility to ensure economic stability.

Let Greece free up its labor markets to 21st century northern European standards, by all means, but imagining that Greece could increase flexibility to anything approaching that of 19th century Europe is quite batty.