07/18/2012 02:29 pm ET Updated Sep 17, 2012

The European Debt Crisis: An Alternative Solution

Euro zone leaders' latest plan to rescue the euro, agreed to late last month, focuses on two crises: the continent's ailing banks and the sovereign-debt woes of Europe's southern peripheral economies. Unfortunately, their blueprint neglects a third crisis that continues to grow and could bring down the euro zone: Greece, Ireland, Italy, Portugal and Spain are becoming increasingly uncompetitive economically relative to Germany.

Most economists agree that renewed economic growth is essential for saving the euro. The problem is that the effects of measures such as creating a banking union, the centerpiece of the recent summit's rescue plan, may save the banking system but will do nothing to reverse the loss of competitiveness among the region's economies. The euro zone can't wait much longer, as the steadily rising borrowing costs of Spain and Italy demonstrate. It needs to start growing now, and the fastest and surest way to stimulate growth without increasing deficits is for Germany to accept a much looser monetary policy and the consequent higher inflation to help restore the competitiveness of Europe's peripheral economies.

Figures from the Organization of Economic Cooperation and Development indicate just how uncompetitive these economies have become. Between 1995 and 2007, German unit labor costs fell by three percent, while these costs rose 61 percent in Greece, 30 percent in Italy, 40 percent in Ireland, 42 percent in Portugal and 40 percent in Spain. These widening competitive gaps have translated into lower -- and now negative -- economic growth and increasing unemployment.

Not surprisingly, their competitiveness disadvantage shows up as large current account deficits for these five countries and a whopping surplus for Germany. Take Spain, Europe's fourth largest economy. In 2001, its deficit was four percent of GDP. Today, it's 10 percent. By contrast, Germany's has gone from a slight deficit to a surplus of 7.5 percent of GDP.

The currently preferred solution to restore competitiveness in the euro zone is "internal deflation." In practical terms, it means austerity in the form of less government spending, cuts in pensions and wages, and higher taxes. The economic pain supposedly puts downward pressure on wages and prices, thus making a country's exports cheaper relative to its healthier neighbors.

But austerity has not meaningfully brought prices down. Ireland, which has most faithfully taken its austerity medicine, has seen just a 1.7 percent drop in its labor costs from 2007 to 2011. Greece's and Italy's costs have kept pace with Germany's, while Spain, whose unemployment is at historic levels, has managed only to hold costs essentially flat.

Far from closing the competitiveness gap, austerity has strengthened the vicious circle of already shrinking economic output in the peripheral countries, further weakening their abilities to pay down their debt. As the latest numbers out of Europe show, the economic malaise is spreading to the overall euro zone economy. Unemployment hit a record high in May, and manufacturing activity is contracting across the region, with weakness in Germany hitting a three-year high.

A higher average inflation rate in Germany can help reverse this slide. But so far, the country has opposed any policy that might stoke inflation. Two horrendous periods of hyperinflations after the world wars still haunt Germans.

But Germany exaggerates its inflation concerns. OCED data show that from 1971 to 1991, when the move toward a single currency began, Germany's inflation rate averaged four percent. During that time,real GDP grew, on average, 2.4 percent a year. Since then, annual inflation has averaged two percent, and GDP growth an anemic 1.3 percent. During its unification with East Germany, Bonn accepted an inflation rate greater than five percent in 1992 and four percent the following year.

Germany's current inflation rate is 1.7 percent. At that rate, Spain would have to suffer a 13 percent fall in wages and prices, relative to Germany's, to correct a 20 percent competitiveness imbalance over four years. That kind of economic pain is a recipe for political instability, with Greece the model.

Germany has too much riding on the success of the euro to persist in its anti-inflation mania. Its leaders have not been forthcoming with voters about the role the euro plays Germany's economic success. The euro's value, which essentially represents the average competitiveness of the 17 nations in the currency bloc, makes German goods far cheaper abroad than they would be if the deutsche mark were the country's currency. A collapse of the euro would lead to a rapid appreciation of a stand-alone deutsche mark, and it will throw Germany's economy into serious recession.

Last week, the European Central Bank cut its interest rate to 0.75 percent, a historic low, amid signs of deteriorating economic activity in Europe. It needs to go lower. For that to happen, Germany, which has outsize influence on the central bank, needs to abandon its obsessive insistence on miniscule inflation and nothing-but austerity and accept a higher inflation rate. Given its recent history, a rate of four or five percent would seem sustainable without causing economic havoc, while helping to restore competitive balance on the continent. A little more inflation in Germany is in its self-interest.

Aris Protopapadakis is associate professor of finance and business economics at USC's Marshall School of Business.