How to Solve the European Sovereign Debt Crisis

“It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

That is what is needed to resolve the European sovereign debt crisis. So says Christine Lagarde, the managing director of the International Monetary Fund. (link)

Need one say more?

But, she stated, the world economic outlook “is quite gloomy” with a pervasive downside risk.

So, the international community must work together.

Working together means that, starting at the core…the European countries…economic and fiscal union must be achieved. This would be attained through fiscal solidarity and risk-sharing around the globe.

Unfortunately, one has to ask…is this “actually facing the issues…accepting the truth…accepting reality…” or is it just another way to postpone what needs to be done for a while longer?

My blog yesterday discussed the underlying economic dilemma faced by the European nations. Over the past ten years or so, unit labor costs in Germany have increased 20 percent to 30 percent less than in other eurozone countries. (link) That is, German labor has consistently become more productive than non-German labor.

And, the non-German countries, in an attempt to keep their labor as fully employed as possible given the divergence in labor productivity, engaged in programs of fiscal stimulus which created a credit inflation that was unsustainable. Hence, the sovereign debt crisis.

Since the eurozone is subject to a single monetary authority and a common currency, fiscal budget tightening, at this time, can only bring on the “pain and suffering” of a recessionary restructuring.

The problem is that countries within the European Union have been allowed to get “out-of-line” with one another, economically. And, in a union of countries like this, nations cannot “paper-over” the differences in labor productivity by the creation of lots and lots of debt. In fact, such behavior only can exacerbate the problem.

The countries in the European Union are facing a need for a massive restructuring of their economies, their labor markets, and their industrial structure. Yet, “fiscal solidarity and risk-sharing” will not do this job.

As I mention in my blog post yesterday and Alan Blinder states in his op-ed piece in the Wall Street Journal we have reached the stage where the only possible solution may be a substantial change in how people do things.

According to Blinder, the only path left may be debt deflation. The countries, other than Germany, “can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—which generally happens only in protracted recessions.”

A possible response to this, however, is social unrest. We have already seen protests in Greece, and Spain and Italy and France… But, protests have become a worldwide phenomenon. We have protests in Russia. These movements are also seen as a kin to the events of the Arab spring. Furthermore, there are the “Occupy” efforts…in the United States…and in other parts of the world that cannot be totally divorced from these other events. Modern information technology is being felt everywhere.

It is difficult to see how the protests and unrest in the non-German countries of the eurozone are going to resolve the situation. Just as with the idea of “fiscal solidarity and risk-sharing”, a movement that does not address the fundamental misallocations that exist within these societies will not come up with viable alternative solutions.

The issue is that many countries are “out-of-line” economically. German labor productivity exceeds that of other European nations. The industrial structure of Germany is more competitive than the non-German eurozone countries in the global marketplace.

I am not in favor of returning to a world of mercantilism, as I mentioned in yesterday’s blog. But, as many emerging nations have recently managed their economies so as to improve their relative position in the world, those developed countries that have focused just on buying off labor unrest over the past fifty years, may have to alter their approach to how their economies are managed. “Soft” solutions will only enlarge the gap they face with more competitive nations.

Remember, one conclusion about the internal management of a nation’s economy within the framework of world trade is that a country can only choose two of the following three alternatives available to them: the nation can have a fixed exchange rate; it can have a free flow of capital internationally; or it can conduct an economic policy independent of all other countries. This problem is referred to as the “trilemma.”

Well, the countries within the eurozone have a fixed exchange rate and they have a free flow of capital internationally. Therefore, they cannot conduct their economic policies independently of the rest of the world.

The only thing left for these countries to do is to create an environment in which the productivity of their labor and capital become more competitive within world markets. If not, the most productive capital and labor will move on to other nations.

This solution has little to do with “fiscal solidarity and risk-sharing.”

The labor and capital utilization within the countries that are not doing so well…must be restructured.

As managing director Christine Lagarde stated, “It’s a question of courage or actually facing the issues, not being in denial, accepting the truth, accepting the reality and then dealing with it.”

I’m not sure she is there yet…but neither are a lot of other people.

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