The heavily indebted countries such as Greece, Portugal and Ireland are caught between a rock and a hard place. The economies have deteriorated and the jobless rate has shot up to double-digit rates. These countries have no ability to create money, nor the option of depreciating its currency like they used to. The only alternative is to further shrink the economy in order to increase exports and suppress imports leading to a better balance of trade. Under the current economic circumstances, it is tough to boost exports. Creating more unemployment in the current situation is politically difficult.
The cost of labor adjusted for productivity gains is the primary tool of competition among the members. Unfortunately, costs have risen much faster in some countries than others. Between 2000 and 2010, the unit labor cost, which reflects productivity changes, rose 33 percent in Greece, 30 percent in Spain and 27 percent in Ireland, while it rose only 5.8 percent in Germany.
Consequently, the common currency, the euro, worked to the advantage of Germany and at the same time hurt the export competitiveness of countries such as Greece, Portugal, Spain and Ireland.
If Greeks and Spaniards could pay for German goods with their depreciated pesos or drachmas, the competitive position of the countries in the Euro-zone could be rebalanced. Instead, everyone in the zone uses the euro.
In reality, Germany is competing with an undervalued currency which is super-competitive. The Euro-zone buys 43 percent of German exports. At the other extreme, the deficit-laden countries including Greece, Portugal, Spain, etc. are operating with an overvalued currency that is uncompetitive.
As Professor Mundell’s criteria for the Optimum Currency Area showed, the current composition of Euro zone makes for strange bedfellows. Two countries as different as Germany and Greece can’t coexist under a single currency. Portugal has little to export. They compete with emerging markets so that the wages would have to be cut to the emerging market level. The same is the case for Greece.
The breakup of the Euro zone is not out of the question. Two optimum currency areas instead of one may make more sense.
One option is to divide the zone into North and South. North would include more homogeneous countries including Germany, France, Netherlands, etc. South would include the Mediterranean countries such as Spain, Greece, Portugal, etc.
Another option is for Germany to leave the Euro zone. As discussed earlier, the presence of Germany in the zone causes some of the problems facing the operation of the zone. The German disappearance could solve many of the thorny problems discussed in this report.
Splitting the Euro-zone could be a win-win solution to the current economic dilemma