How we can avoid another Mediterranean crisis

by Edmund Phelps

Financial Times
January 11, 2012

Many economists ascribe the crises in the eurozone to the workings of the misbegotten monetary union. And they blame the victims for joining it! When switching in 1999 to the euro, Italy, Portugal and Greece valued their previous currencies so highly that they became uncompetitive, especially vis-à-vis the north. Bereft of their own currencies they could no longer devalue to reduce nominal wages and make their workers relatively cheaper. But these economists never explain why, if labour was so overvalued, markets did not prevent wage increases, reducing prices in the process, thus devaluing the currency in real terms.

This perspective ignores some market forces and policies that are unrelated to the formation of the monetary union – those that fueled wage demands in southern economies by causing household savings to rise relative to labour productivity. This is econ 101: when a family is richer, its older workers demand higher wages to stay in work and its younger workers demand higher wages to take a first job. The dynamic contracts available jobs unless offset by an equal or greater rise in productivity.

But instead of this, we saw sharp productivity slowdowns. Italy, after four decades of rapid advance, saw its productivity come to a shuddering stop between 1996 and 1998: productivity growth fell from 2 per cent per year in 1984-1994 to just 0.1 per cent per year in 2000-07. Household saving suddenly dropped and decreased throughout the 2000s, but it has not stopped entirely. It would have made no sense for Italians to stop saving, as if the world was at an end. Portugal, after growing faster than Italy for a couple of decades, in the 2000s saw its productivity growth slow to rates almost as low as Italy’s.

A policy of fiscal deficits also invited rises in wealth. From 2001 to 2007, Portugal and Greece left wide gaps between state outlays and revenues, believing that higher taxes would snuff out jobs. Families saved much of these state “bonuses”, adding significantly to their private wealth – at the expense of future taxpayers or bondholders. (Italy’s public debt was so large that inflation offset its deficits.)

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