Time Fast Approaching for EU to Abandon the Euro

As Italy teeters on insolvency and the euro on collapse, European leaders are desperately seeking amendments to EU treaties that would legally limit national budget deficits. However, a new fiscal discipline would not address fundamental flaws in the euro architecture that caused Mediterranean states to become uncompetitive and borrow too much.

In the last week, Germany could not sell a significant share of a new bond offering, France and other stronger governments saw interest rates on their bonds rise to alarming levels, and European banks are scrambling to hold onto deposits and raise collateral to finance borrowing from the European Central Bank.

Capital markets are locking up, because large institutional investors recognize what French President Sarkozy and German Chancellor Merkel seem unable to accept-the euro makes little sense.

When the euro was created, wages, private debts and government bonds were converted from national currencies into euro according to prevailing exchange rates at the end of 1998. To the extent those rates reasonably reflected market prices, the euro adequately priced labor, private contracts and public debt across borders.

Unfortunately, those cross-border relationships change over time. Member states in the currency union have labor market policies, tax systems and social programs that vary more widely than those of the 50 U.S. states. As productivity and investment grew more rapidly in Germany and other strong economies, labor and exports became overpriced in Greece, Italy and other troubled economies.

Generally, the ECB has not intervened in foreign exchange markets and the value of the euro has tended to reflect wages, productivity and economic strength of the 17 euro countries as a whole. The upshot-the euro is undervalued for the German economy, making it an export juggernaut, and woefully overvalued for Greece, Italy and other Mediterranean countries making them debtor states.

For the latter, imports were financed by private borrowing from stronger EU states-Mediterranean country banks financed some mortgages and consumer debt by borrowing from German and French banks-and by governments borrowing from abroad-Mediterranean states sold bonds to German and French banks.

Sovereign borrowing shored up social programs made expensive by less productive private sectors and padding public payrolls to hide unemployment. Now these governments owe more than they can repay under any reasonable scenario for European growth rates and future borrowing costs.

Austerity and loans from Germany, France and other strong governments won't help. To pay what they owe, even with large haircuts for private creditors, Greece, Italy and other troubled economies must earn euro by exporting much more than they import. However, the structure of the Euro Zone leaves their labor and exports too overpriced, unless they endure tortuous recessions for 5 or 10 years to sharply push down wages. Even such deflation may not be enough to make their economies competitive.

The draconian austerity prescribed by Germany would leave those economies with insufficient infrastructure and outdated private capital. No matter how much wages fell, those handicaps would keep overall productivity too low for exports to be competitive.

The only sane option is for Greece, Italy and other troubled economies to reform social programs, drop the euro, remark public and private debt to the reestablished national currencies, and let falling values for those currencies in foreign exchange markets impose haircuts on creditors.

Devaluation would permit the Mediterranean economies to increase exports and repay more of what they owe. The losses imposed on creditors by devaluation would be much less than the losses they will endure in the panic building in European capital markets and long recession that now appears inevitable.

Prior to the euro, the EU enjoyed much success facilitating intra-continental trade, and an orderly demise of the failed experiment in a common currency could permit the EU to hang together.

If Germany and France continue to cling to the myth the euro is essential to European unity, the EU will likely collapse altogether in the acrimony of the sovereign defaults and bank failures that follows.