There are some things that reasonable people can largely agree on regarding the eurozone's problems: the monetary area is stuck in a crisis that has brought about unbearable unemployment to southem Europe. That problem cannot be solved satisfactorily through deflation since that would make bankruptcies soar among over-indebted households and companies. The crisis was triggered by the US financial turmoil and Germany accumulated large current account surpluses after the introduction of the euro that are the mirror image of the distressed countries' deficits.
But reasonable people can differ: Niall Ferguson wrote recently in the Financial Times that the euro helped Germany because it created current account surpluses at the expense of the southern countries. This view is wrong. Current account imbalances are capital flows. When capital flows from country A to country B, A slows down and B experiences a boom. The booming country's imports rise, while rising wages depress its exports. The opposite holds for the partner people. For that reason alone it is absurd to say that a country "profits" from a current account surplus or "suffers" a deficit. That notion was laid to rest in the 19th century.
The now-troubled countries were the recipients of the capital mobilised by monetary union. The euro eliminated exchange risk so investors in the southern countries accepted lower yields. Capital inflows fuelled booms that turned into bubbles, causing massive current account deficits. The bubble burst when investors refused to continue financing these deficits, leaving uncompetitive economies.
Germany, under the euro, was the largest capital exporter and plunged into a deep slump. Only one-third of its savings was invested at home. As a result, during the early years of the euro, its net investment and growth rates were the lowest in Europe. Rising unemployment forced the Schröder governwent in 2003 to enact painful social reforms. When the euro was announced in 1995, Germany's gross domestic product per capita was the second-highest among the current euro countries. Now it is seventh. That's not exactly the performance of a "euro winner".
Things started to perk up for Germany only after the credit bubble in southern Europe burst, because it became a safe haven for its savings. Confidence in German property fuelled a construction boom which, if capital is not artificially escorted abroad, will gradually eliminate the current account imbalances.
Herein lies another disagreement between us. Prof Ferguson suggests institutionalising redistribution among the euro countries through a deposit guarantee, a eurozone budget and eurobonds. These would perpetuate the structural differences in competitiveness that arose from the southem European credit bubble.
They would maintain wages that do not reflect productivity and would turn a temporary crisis into chronic malaise. They would also revalue the euro, further undermining the crisis hit countries' competitiveness. Muddling through is the only solution. Germany must accept more inflation while the southern countries reduce theirs to bring about the necessary realignment of relative prices. This process, not much in evidence among the crisisstricken countries bar Ireland, requires tough austerity measures.
Only modest lending between governments will therefore be required. The European Stability Mechanism has already been generously endowed for this task.
Countries that cannot cope should be allowed to exit the euro and be readmitted after they have devalued and implemented structural reforms. The eurozone is no unitary federal state; the euro cannot function as the dollar does. It should be somewhere closer to the old Bretton Woods currency system, under which countries could exit and re-enter at different prices. Greece would benefit from orderly exit followed by devaluation. Exit should be accompanied by haircuts that convert debt into national currencies and an option to reenter at a later date would strengthen the country's zest for reform. A common debt moratorium for overly indebted countries not exiting the euro may also be needed.
This implies risks for investors. But the risk posed by mutualisation of debt through eurobonds is much greater, as US history shows. After the US mutualised state debts in 1791 and, again, after the second war against Britain in 1813, states went on borrowing binges. A credit bubble emerged that burst in 1837 and pushed more than half of all states into insolvency. As Harold James of Princeton has shown, the only result of debt mutualisation was strife.
The US and Switzerland have nobail-out clauses for states and cantons. Otherwise, they would have to bestow upon their central governments intrusive intervention rights. But a european federal state, if ever established, will surely not be more centralistic tban the US or Switzerland. No matter how you look at it, mutualising debt is indefensible.