There were both economic and political reasons why the euro was developed as a project and both economic and political reasons why countries such as Greece should have stayed out. When a country suffers from an adverse economic shock, living standards must decline. Greece has suffered from a huge economic shock and one that has been exacerbated by its membership of the single currency. If a country has a floating exchange rate, the currency of the state suffering from the shock will normally find that it falls in value. It is this that facilitates the reduction in living standards. A country that is in a fixed exchange-rate regime cannot easily adjust its living standards, unless there is a huge fall in real wages in the country concerned. When inflation is close to zero, this means a fall in nominal wages too.
This is the backdrop to the problems in Greece. If, as a young economist, one was to paint a picture of all the problems that would make economic adjustment difficult, one could not do better than to look to Greece – a huge public sector; exceptionally rigid working practices; a dysfunctional tax system; minimum wages. The list is almost endless. To cap it all, the Greek government also has an unsustainable debt burden. This problem is exacerbated by the fall in living standards in Greece – as gross domestic product falls, the debt burden relative to income goes up.
Therefore, there are four aspects to the "Greek problem". The first is ensuring that there is a mechanism to enable wages to fall in the private and government sectors – this is what the so-called austerity measures are all about. Of course, if living standards are falling, this must involve a cut in services provided by the government too. Secondly, we need huge reforms to ensure that there is greater productivity growth and more flexibility in the economy. Relatively speaking, this is the painless side of things – though, reform will be obstructed by the vested interests. Greater productivity growth and greater flexibility will allow austerity to come to an end and the economy to become prosperous again.
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