Euro Crisis: Germany is the Key

For those who can read French, my saturday article in Le Figaro (written with Philippe Villin) is now downloadable (ungated version) on my website here.

Since the Eurozone has been proved not to be an OCA, and since the extreme and unreasonable assumption that a non optimal currency zone would become optimal as soon as a common currency is created (the "endogenous OCA hypothesis") has been decisively proved wrong, Germany is responsible for having imposed its "mark rule" upon naturally more inflationary countries such as Greece, Spain and Italy.

No longer able to mitigate their loss of competitiveness by currency devaluation, these countries -- hard hit by exchange rate external over valuation in the midst of a deep recession and structural internal over valuation relative to Germany, as embedded in the definition of the euro and aggravated by subsequent relative evolution of inflation rates -- have used in return the moral hazard incentive provided by the strong euro to absorb part of the recessionary shock through fiscal policy, i.e. increased deficits, without having to pay for increased default risk through interest rates premia.

If Greece, and Spain, have to be spared the unbearable burden of deflation added to recession, with catastrophic social and political consequences, Germany has to help to convince the ECB to adopt a more lax monetary policy stance, while accepting at home larger budget deficits (through tax cuts, not inflated public spending) and euro depreciation.

But in the longer term, in a non optimal currency area, a durable solution can only come from the exit of the country which is the most different from the other, average members, in its economic structure and inflation requirements, that is to say Germany. While an exit of Greece or Spain could wreak havoc on their banking systems, a German exit is obviously possible without determining a run on German banks. On the contrary it could attract international capital flows anticipating a revaluation of the New Mark.

The situation is similar to that of the 1930s when the exit of European countries from the Gold Standard, after a long and unsuccessful struggle to keep it, conditioned the return to growth. Today the European countries must get out of the mark standard embedded in the current euro.

Germany, not Greece, is the main immediate problem of the eurozone.