Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Resrve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank. He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society.
Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.
“The Italian election, like the French election earlier, showed the public in both countries unwilling to continue five years of endless austerity with no program to restore growth. Other elections in troubled countries are likely to produce a similar result.
On a recent visit to Greece, French president Hollande announced that Europe’s decline was over. Would that it were so, but Italian voters were right not to agree. President Hollande urged French companies to invest in Greece. Bad advice. French costs of production are high, but Greek costs are higher. Despite the considerable decline in Greek, Italian, and Spanish real gdp since 2007, adjustment is far from complete.
Before the Italian election, financial markets showed signs of optimism, encouraged by the ECB policy of supporting borrowing country debts, expanding its balance sheet and lowering interest rates. As owners of debt issued by the indebted countries, lenders gain when interest rates fall. But unemployment rates continue to rise in the indebted southern countries, and with the important exception of Germany and a few other northern countries, production and output continue to lag.
The main reason for the lag is not simply low demand or large debts. Production costs—unit labor costs, real wages adjusted for worker productivity—are vastly different in Germany and in the heavily indebted southern countries. When the crisis began, production costs in Greece were about 30 percent higher than in Germany, so Greece produced very little and imported much. Production costs in other heavily indebted countries were 20 to 25 percent higher than in Germany. That’s a big burden to overcome before growth resumes.
Growth will not resume until production costs in the indebted countries decline. That requires either a substantial permanent increase in productivity, a reduction in real wages, or both. Some adjustment has occurred but, alas, much of the change is not permanent. Austerity reduced the number of employed workers, many of them with little skill and low productivity. Gains in measured productivity growth from this source are not permanent changes, so a large part of the reported reductions in unit labor costs are temporary.
Some adjustments have occurred but major cost differences remain. In Greece, the private sector has been forced to adjust, but the Greek government failed to keep its promise to reduce public employment. That will maintain excessive government spending, and deficit targets will not be met on a sustained basis. Large reductions in public sector wages brought the primary deficit down, but redundant public sector workers lower public sector productivity, raise costs, and delay adjustment.
In Italy, the Monti government undertook some reforms, but the government continues to support union and corporate monopolies. And the Italian parliament did not agree to many of Monti’s proposed reductions in government spending. Labor and many product markets remain closed, far from the open, competitive markets needed to increase competition, lower production costs and raise productivity.
After five years of slow growth, high and rising unemployment rates, the prospect rises that voters in other indebted countries will, like the French and Italian voters, reject additional spending reductions, tax increases and more painful deregulation. Europe must find more effective policies that reduce costs of production toward Germany’s. In his recent book, Professor Harold James showed that in the 40 years of negotiations leading to the adoption of a common currency, all of the problems that now beset the Euro-zone were discussed repeatedly. Everyone understood that a common currency required enforceable fiscal and banking rules. That didn’t happen.
Before there was a Euro, countries adjusted misaligned production costs by devaluing or revaluing exchange rates. Fiscal austerity is a poor substitute. It works slowly, if at all, because elected governments are reluctant to implement promises. A majority of voters rebel against years of austerity with no evidence of renewed growth. And politicians are reluctant to adopt deregulation that eliminates state sponsored special privileges. Further, austerity brings out a political opposition that promises to restore growth and end austerity.
For several years, I have proposed a policy that combines growth and fiscal rectitude. Let all the heavily indebted currencies jointly agree to join a weak euro. Let the weak euro float against the stronger northern euro. When the weak euro reduces production costs of the heavily indebted, southern countries by 20 or 25 per cent, the southern countries can rejoin the “hard” euro, if they accept fiscal reforms that are hereafter subject to approval by the Brussels bureaucracy or the northern countries. If they do not accept fiscal restraint, they cannot rejoin the hard euro. A fixed exchange rate or common currency requires limits on fiscal independence.
The Italian election returns sent a message. After five years of decline in living standards, voters oppose more austerity and further restraint without growth. Restoring a sound euro requires policies that restore growth while ending expansionist government policies and heavily regulated labor and product markets.
Allan H. Meltzer is the Allan Meltzer University Professor of Political Economy at the Tepper School, Carnegie Mellon University and Distinguished Visiting Fellow at the Hoover Institution. He is the author of Why Capitalism?, Oxford 2012.