The economic medicine being applied in Europe is not working. In fact, the patient is getting worse: Greece's economy is collapsing and its debt is rising exponentially, prompting harsher austerity proposals and increasingly violent protests, such as the one on Oct. 19 in front of Athens's parliament. The doctors have responded by prescribing ever-larger doses of the same: ever-larger funds to lend Greece ever-larger amounts and force ever-larger austerity measures upon the country -- a course that can only lead to an ever-larger failure.
And yet the underlying problem is both familiar and resolvable: several governments in Europe have borrowed more than they can possibly repay. Such over-borrowing by governments is not unusual. It has happened repeatedly over the years and has one effective solution: the debt needs to be reduced. This is hardly impossible -- Mexico, Brazil, and seven other Latin American governments did it two decades ago following the prolonged debt crisis of the 1980s, reducing their respective debts by 50 to 70 percent by issuing tradable dollar-denominated "Brady bonds" in exchange for their outstanding debt. Banks took large losses, long foreseen by the markets, and proceeded to rebuild their capital. Prosperity was quickly restored to the over-indebted countries.
Tragically, the eurozone leadership has for three years refused even to consider this most obvious of solutions. Instead, the leadership has been determined to raise ever-larger "bailout" funds to lend ever more to the stressed governments. These new European Financial Stability Facility (EFSF) loans do forestall default in the short term, but they add to the debt total of Greece and other stressed countries and so make the long-term problem far worse. If a borrower has too much debt, one does not help him out by lending more -- that only digs him in further. This is not a "bailout" at all. The defaults, when they come, will only be larger. The markets clearly see this: Sovereign bond rates and credit-default swap spreads, which are closely related to the probability of default, keep climbing ever higher.
Why has the euro leadership been acting in this perverse and dysfunctional way? It is because they desperately fear contagion. If the gift of Latin America-style debt relief is offered to Greece, surely Portugal will be next in line, asking for the same favor. Then comes Ireland -- where government officials have already said their country should be included in any resolution of Greece's problems -- likely followed by others. How could one say no to them after saying yes to Greece? Where would the cascade of losses end? Contagion is the central problem that needs to be addressed.
The way out of this bind is to create a downside to debt relief: It should be available, but must come with sobering consequences. I propose a simple tradeoff: Any country that accepts a wholesale debt reduction must agree to leave the euro.
At first, this prescription sounds harsh and extreme, which may explain why it has received the endorsement of some economists but few politicians or policymakers. In reality, however, the tradeoff offered is benevolent and appropriate. Greece is too unlike the other eurozone countries, and in fact, it owes many of its current problems to the decision to join in the first place. Leaving the euro will unshackle it from the terrible position in which it finds itself. The short-term costs would be considerable, but they are greatly exceeded by the short-term costs of endless, wasted bailouts.
Why? Look at the fundamentals. Greece is less productive economically, and has less productivity growth, than the nations of northern Europe. Productivity growth has enabled Germany to keep inflation low for decades; Greece has had no such luck. Before Greece joined the euro in 2001, its drachma steadily devalued relative to the currencies of northern Europe, an expression of this difference. The ratio of Greek currency value to German currency value dropped by 93 percent between 1976 and 2001. This steady change in relative currency value enabled trade between Greece and northern Europe to expand without significant payment imbalances, to both sides' benefit.