Thursday, April 29, 2010

Lipstick on PIGS

OK, that's a bit lame.

But anyway, the Greek situation, which risks spreading to Portugal, Spain and probably ultimately Italy too, reminds us that the implications of EMU for Southern Europe haven't been adequately debated or understood. When the euro came along, it had two immediate effects: it made issuing bonds easier for Southern governments, and it led to significant hikes in prices for basic necessities. But the longer term issues were barely discussed by anyone (Krugman is the usual exception).

The point is that these countries all had a history of high inflation, and dealing with competitiveness problems through devaluation. All of that was forgotten for a while, as the euro provided an inflationary anchor (notwithstanding the annoying price hikes - caffe' 1000 lire, caffe' 1 euro) and competitiveness problems crept up gradually, and were largely masked by capital inflows (in Spain and Greece, at least, not in Italy where they came out as glacial growth rates).

Now the hot money has gone, and a brutal adjustment awaits. These countries all have high unemployment, high inequality, and lots of tax cheating and corruption. I can't see low and middle income people accepting the cuts in nominal wages that are going to be needed. It's not going to be pretty, and it could mean back to drachma.