Forgive them their debts’ is not the answer
WHAT is the relationship between money and nations? The main building of the International Monetary Fund in Washington DC is shaped roughly as an ellipse. As you walk around the corridor on the top floor, on one side are symbols of each of the member nations. On the opposite side are display cabinets of the banknotes used by those countries. There is a remarkable, almost uncanny, one-to-one relationship between nations and their currencies. Money and nations go hand in hand. European Monetary Union (EMU) is the most ambitious project undertaken in monetary history. EMU has not proved to be an easy marriage, with the enterprise trying to navigate a safe passage between the Scylla of political ideals and the Charybdis of economic arithmetic.
European Monetary Union (EMU) is the most ambitious project undertaken in monetary history. How long this marriage will last is something known only to the partners themselves; outsiders cannot easily judge the state of the relationship. The basic problem with a monetary union among differing nation states is strikingly simple. Starting with differences in expected inflation rates - the result of a long history of differences in actual inflation - a single interest rate leads inexorably to divergences in competitiveness.
Some countries entered European Monetary Union with a higher rate of wage and cost inflation than others. The real interest rate (the common nominal rate of interest less the expected rate of inflation) was therefore lower in these countries than in others with lower inflation. That lower real rate stimulated demand and pushed up wage and price inflation further. Instead of being able to use differing interest rates to bring inflation to the same level, some countries found their diver- gences were exacerbated by the single rate.
The resulting loss of competitiveness among the southern members of the union against Germany is large, even allowing for some overvaluation of the Deutschmark when it was subsumed into the euro. It increased full-employment trade deficits (the excess of imports over exports when a country is operating at full employment) in countries where competitiveness was being lost, and increased trade surpluses in those where it was being gained. Those surpluses and deficits are at the heart of the problem today. Trade deficits have to be financed by borrowing from abroad, and trade surpluses are invested overseas.
Countries such as Germany have become large creditors, with a trade surplus in 2015 approaching 8pc of GDP, while countries in the southern periphery are substantial debtors. Extract one: Lord Mervyn King: why throwing money at financial panic will lead us into a new crisis The situation in Greece encapsulates the problems of external indebtedness in a monetary union. GDP in Greece has collapsed by more than in the US during the Great Depression. Despite an enormous fiscal contraction bringing the budget deficit down from around 12pc of GDP in 2010 to below 3pc in 2014, the ratio of government debt to GDP has continued to rise, and is now almost 200pc.
All of this debt is denominated in a currency that is likely to rise in value relative to Greek incomes. When debt was restructured in 2012, private- sector creditors were bailed out. Most Greek debt is now owed to public- sector institutions such as the European Central Bank, other member countries of the euro area, and the IMF. Fiscal austerity has proved selfdefeating because the exchange rate could not fall to stimulate trade. In their 1980s debt crisis, Latin American countries found a route to economic growth only when they were able to move out from under the shadow of an extraordinary burden of debt owed to foreigners.
It is evident, as it has been for a very long while, that the only way forward for Greece is to default on (or be forgiven) a substantial proportion of its debt burden and to devalue its currency so that exports and the substitution of domestic products for imports can compensate for the depressing effects of the fiscal contraction imposed to date
The inevitability of restructuring Greek debt means that taxpayers in Germany and elsewhere will have to absorb substantial losses. It was more than a little depressing to see the countries of the euro area haggling over how much to lend to Greece so that it would be able to pay them back some of the earlier loans. Such a circular flow of payments made little difference to the health, or lack of it, of the Greek economy. It is particularly unfortunate that Germany seemed to have forgotten its own history. At the end of the First World War, the Treaty of Versailles imposed reparations on the defeated nations - primarily Germany, but also Austria, Hungary, Bulgaria and Turkey.