Lost Competitiveness for Greece and Spain - Is There a Way Out?

Using ECB data the chart below shows the substantial loss of competitiveness for Greece and Spain since 2000. With flexible exchange rates against Germany there is no doubt that the countries would have allowed their national currencies to depreciate against the mark. That would have allowed an improvement in the external balance.

With the euro straightjacket, however, the only way to restore competitiveness and give hope for future economic growth is to reduce unit labour costs by following austerity programs and implementing supply side changes that could promote investment and the return of confidence. Of course, the unpopularity of such programs is directly proportional to their severity, making their advocacy by politicians difficult. And the actual implementation can be even trickier...

Does this mean that abandoning the currency union is the only way out? Recent history teaches us that 'artificial' pegs (i.e. pegs that involve significantly dissimilar economies) are indeed prone to disintegration. Think of the UK's exit from the ERM mechanism in 1992 and the Argentinian abolition of the peg with the US dollar in 2002 - is there another spectacular peg disaster in store for 2012? 

The problem is that de-pegging in a disorderly way is bedevilled by dangers. High inflation, the collapse of the banking system, violent income redistribution, deep recession and social disorder are some of the possible scenarios for the day after. So, whenever there is a choice policymakers normally prefer the (costly) status quo than the (potentially disastrous) alternative.

So what should Greece and Spain do? 

I think more or less what they are already doing. Fighting tooth and nail to stay in the eurozone (EZ). If the Germans are serious about the viability of the euro experiment (and I think they are) they will eventually have to consider a more accommodative monetary policy (leading to a higher inflation that would erode the real value of existing debt), some form of eurobonds to allow countries in difficulty to borrow at lower rates and potentially more debt write-downs for the criminally indebted nations. The EZ banking system will need to be reinforced as well.

As long as Greece and Spain implement the necessary structural changes (the Greeks have been given a handy MoU with detailed instructions by their creditors), such changes would eventually allow these countries to grow again. No doubt, this is politically explosive stuff in Germany and that's why time is needed to prepare the public for the price they need to pay. (For the Greeks that time is now.) Unfortunately, the markets are pressing hard and a clear roadmap to an "ever deeper union", fiscal and political, will need to be presented sooner rather than later. 

Too much is at stake and everyone should do their bit. The rich EZ "North" should help the poorer "South", and the South should undertake painful but necessary economic adjustments. It is in the interests of everyone involved -and the rest of the world.

You can read more about the harmonised competitiveness indicators at the ECB's website.