Third Post on Europe: A Modest Proposal

Finally, my crazy idea.  I want to emphasize that I think this is probably dangerous and in any case almost certainly an unworkable proposal.  But it is interesting, and that is enough of an excuse to blog about it.  As always, remember that I am not an economist, so take this gyda graen mawr o halen.

As we have been discussing, Europe faces a severe balance of payments problem that cannot be addressed by devaluation.  Instead, it is probably necessary to run differential rates of inflation in northern and southern Europe in order to restore balance.  Ideally this would be something like 5% inflation in northern Europe and 1% inflation in southern Europe, but it seems the northern Europeans will insist on 2% inflation in northern Europe and 2% deflation in southern Europe.  To achieve 2% deflation would require insanely high levels of unemployment.  This is not really feasible because it implies a collapse in (A) northern Europe's biggest export market, and (B) tax revenues in southern Europe—so in a sense the sovereign debt crisis is something that is being imposed by the northern Europeans.

In light of all this, here is my admittedly crazy proposal.  Assume that we need to achieve massive deflation in southern Europe (remember, I think this is a mistake, I think the right approach is to raise inflation in northern Europe).  And assume that, in the status quo, this will be achieved by subjecting southern Europe to impossibly high levels of unemployment.  Then, as a possibly better alternative, consider this:

Each southern European government legally divides wages into two components.  One is called the "market-determined wage" (I will call it the "market wage" for short), and the other is called the "government-determined coefficient" (I will call it the "government coefficient" for short).  Each person's actual wages are the product of the market wage and the government coefficient.  So by way of example, imagine we have an Irishman named Seamus who is paid €50,000 per year.  At the inception of the policy, we will consider his market wage to be €50,000 and his government coefficient to be 1.  His actual wage is the multiple of these two numbers, so his actual wage is €50,000 × 1 = €50,000.  To start, then, his market wage is the same as his actual wage.

Here's the key, though.  The government (or its central bank) controls the government coefficient.  So Ireland might, as a way of achieving high deflation without grinding unemployment, change the government coefficient to 0.9.  Then Seamus's actual wage is €50,000 × 0.9 = €45,000.  This is the amount his employer is legally required to pay him, regardless of what his employment contract says.  That is, employment contracts are treated as determining the market wage, not the actual wage.  Any attempt to evade the government coefficient would be unenforceable.  So if Seamus's contract says that his employer will "gross him up" (pay him his market wage instead of his actual wage), that provision of the contract will be legally void.  His employer discharges its contractual obligation to Seamus by paying him his market wage × the government coefficient.

However, Seamus is free to negotiate for a higher market wage to the extent permitted by Irish law.  So when his contract is up, he can demand that his employer increase his market wage to restore his previous actual wage.  Moreover, if his employer wants to "gross him up" as a voluntary matter, it can pay him a bonus.  The point is that wages are out of equilibrium in southern Europe.  A one-shot, across-the-board wage cut for all workers would solve a collective action problem and make exports more competitive in one fell swoop.  If workers can then negotiate higher pay, it is because the government has over-shot and wages are actually below what they would be in equilibrium.  That's a (relatively) good state of affairs, because it means that the economy should be restored to something close to full employment.  Going forward, wages should resume their upward course.

First, note that Seamus is probably going to cut his spending, further worsening aggregate demand.  The idea really hinges on a rapid pickup in exports, and that may not happen for a variety of reasons.  Also, to the extent it happens, it implies a hit to demand in northern Europe as its tradeable sector gets hit.  All in all, it seems much worse than running higher eurozone inflation.  But remember, I am assuming that is not an option.

Note also how unfair all of this is to Seamus.  He has presumably arranged his affairs so that he can afford to live on €50,000 a year.  Now he is suddenly being asked to live on €45,000/year, but his debts are not adjusted downward.  If the policy is successful, his expenses will fall somewhat as Ireland experiences a rapid deflation, but there is no guarantee that his expenses will fall enough to make up for the loss of income.

Moreover, some employees have long-term contracts, and they may not be able to re-negotiate them for years, even if wages generally rise.  Probably all employees should be allowed to re-negotiate their contracts no later than 1 year after the government coefficient is changed, regardless of when the contractual term is up.

Finally, people would almost certainly look for ways to slip "gross-up" provisions into their contracts, and the government may not be able to identify them very easily as a legal matter.  This means there might be very unfair differences in the way different workers are affected by a change in the government coefficient.

But look.  You have to compare this unfairness and unwieldiness to the massive unfairness and human suffering that are entailed by the status quo.  To achieve the necessary adjustment is going to be disastrous in any case, but by taking all of its lumps at once, southern Europe can perhaps put its citizens back to work and hopefully stabilize tax revenue.  And once things are growing again, a lot of economic activity can resume.  Better to be growing from a low base than shriveling away from a somewhat higher one.  The big question in my mind is whether this quasi-devaluation would have the intended effect on employment in southern Europe.  Quite possibly not.  Quite possibly, aggregate demand would collapse as workers retrench.  But right now the official policy is to depress aggregate demand at a painful rate for the foreseeable future.  My proposal might not be quite as bad as that.