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Europe’s sterile debate -- austerity vs. stimulus

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May 19, 2012: From left, Japanese Prime Minister Yoshihiko Noda, Russian Prime Minister Dmitry Medvedev, President of the European Commission Jose Manuel Barroso, President Barack Obama, Canadian Prime Minister Stephen Harper and German Chancellor Angela Merkel make their way to a photo opportunity at the G-8 Summit Saturday, at Camp David, Md. (AP)

The European summit this week will feature a standoff between Chancellor Angela Merkel advocating austerity and President Francois Hollande promoting stimulus to boost growth.

Neither position is without merit, but neither by itself will solve what ails Greece and other failing Club Med states. Sadly none of the leaders involved, including the insurgent left most likely to win the next elections in Greece, seem willing to accept that any successful program to put Europe back on track will require abandoning the euro and returning to national currencies.

After the single currency was introduced in 1999, productivity growth was slower and prices rose faster in southern Europe than in Germany and other northern states owing to both cultural and immutable geographic conditions. The latter enjoyed growing trade surpluses at the expense of deficits in the south.

Trade deficits can instigate high unemployment and curb tax revenues, and to support employment and social programs on a par with their northern neighbors, the Greek, Italian and Portuguese governments borrowed too much.

In Spain, northern Europeans purchasing second homes and vacations in its sunny climate instigated a rush of foreign funds into Spanish banks to build dwellings and hotels. Spain actually had budget surpluses prior to the 2008 global financial crisis, and its trade deficits were financed by bank borrowing from foreign sources and questionable loans to homeowners—the American model of excess.

Trade deficits permitted all the Club Med states to consume more than their uncompetitive economies produced by borrowing, in one form or another, but none used the opportunity to boost productivity and regain competitiveness.

When the U.S. banking crisis thrust the global economy into the Great Recession, investors became increasingly aware that Portugal, Italy, Greece and Spain were pursuing flawed economic models and would never be able to pay what they owed. Borrowing rates skyrocketed, pushing governments in all four countries and Spanish banks to the brink of collapse.

To get these economies growing again, all must, as Chancellor Merkel prescribes, spend less money on social programs. Europeans like Americans are living longer and must work beyond current retirement ages or national finances simply can’t work, and they must rid themselves of the notion their government owes them a living.

These economies must become more competitive too by exporting more, importing less, running trade surpluses to earn euro to service debt—this requires lower wages and prices for what they make, as evaluated in euro.

Lacking national currencies, austerity through high unemployment must force down wages and prices. For Southern Europe that would require at least five, perhaps ten, years of unemployment of 25 to 50 percent—that is simply not politically feasible.

Iceland had a banking crisis similar to Spain in 2008, but has it own currency. It let the krona decline against the euro, and its wages as compared to the rest of Europe, fell by as much as 50 percent. It gave continuing support to the unemployed and assisted troubled homeowners more aggressively than the U.S. and other European governments.

The combination made Iceland a competitive and attractive location for investment, and supported the domestic economy as the private sector restructured.

Without the most substantial elements of the fiscal reforms prescribed by Chancellor Merkel, southern Europe cannot become solvent and eventually independent of German aid, but neither can it become strong without abandoning the euro and some reasonable continuing assistance for the unemployed, homeowners and other private debtors.

Germany, Finland and others need to support this course for their own good—their private sectors are quite dependent on southern Europe for customers

Without abandoning the euro, southern Europe will collapse, and it will take Germany and the other northern economies with them.

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist. He is the five time winner of the MarketWatch best forecaster award. Follow him on Twitter @PMorici1.