Greece's Painful Choice

The European Union failed to give Greece a bailout after policy meetings this week—and yields on Greek government debt are rising again as markets remain concerned about the sustainability of the nation's finances. Critics blame the European Monetary Union (EMU)—the foundation of the euro—as the main reason behind Greece's current problems. Simply put, Greece's membership in EMU leaves it unable to employ a classic "quick fix"—a unilateral currency devaluation.

If circumstances were different, devaluation would seem to be a perfect solution. For Greece as a small open economy, a weakened currency would help improve the competitiveness of Greek goods on the world market without a cut in domestic prices or a reduction in wages. Prices of foreign goods would rise, and this would help boost domestic demand. (The U.K. was quite happy to see its currency fall 16% against the euro in 2007 and another 12% in 2008.) Such a policy, however, would come at the expense of other countries, and it would ultimately prompt other countries to devalue their currencies, leaving everyone worse off.

But that's a moot point, as a unilateral devaluation is not an option within a currency union. So what can Greece do to improve its position and tackle its problems?

Germany may hold the answer. Not by opening its purse strings to bail out Greece, but by serving as an example of how a country can cope even with an overvalued currency. Germany was locked into the euro in 1992 with an exchange rate that was far from optimal for its exports. At the same time, it was still trying to cope with the effects of unification, which had proved costly and undermined German competitiveness.

How Germany Did It

Instead of calling for outside help, Germany set on a painful course of improving its competitiveness from within. Wages as well as prices were effectively frozen. German CPI averaged just 0.5% in 1999 and 1.2% in 2000; not before 2001 did Germany post inflation broadly in line with the European Central Bank's definition of price stability, of below but close to 2%. Greek inflation, on the other hand, averaged 2.2% in 1999, still relatively low by Greek standards but 1.7% points above German inflation.

At the same time, German labor cost increases were consistently below the eurozone average. Greek labor cost increases have been volatile but on average run at a high levels. Greek unit labor costs rose 3.3% on average in the 2002-06 period, nearly twice the eurozone average. By contrast, German unit labor costs fell 0.1% during that time.

Ireland, whose budget problems are comparable to Greece's, has started to clean up its act: Its unit labor costs fell 1.9% last year and are expected to decline a further 4.2% this year and 0.9% in 2011, according to the EU Commission. Greek unit labor costs, on the other hand, are estimated to have risen 2.5% last year, with increases of 0.9% expected this year as well as next, compared with eurozone averages of -0.5% in 2010 and just 0.3% in 2011. The upshot: Greek competitiveness will slip further.

A Solution Instead of Postponement

As Greece has been relying on cheap EU funding and credits to boost domestic demand, competitiveness has slipped and its trade deficit has widened. Any cheap funding from the outside would be only a temporary fix, and Greece now faces the same difficult choices Germany had to make after the boom-and-bust cycle caused by unification.

The bottom line is that Greece is facing a necessary structural adjustment process—one that should have started a long time ago. An unconditional bailout would only postpone, not solve, the problem and would come at a considerable cost. Similarly, competitive devaluation may be a quick fix but does not solve underlying problems.

Those who argue that the recent decline of the euro has turned it into a "soft" currency—and could lead to the breakup of the EMU—forget the extent to which the euro has appreciated vs. other currencies since its inception. A correction now will be more than welcome, as the EU struggles to get Greece's financial house in order—and growth back on track for the entire eurozone.