THE BLOG
05/20/2010 09:53 am ET Updated May 25, 2011

Greece's Pieces

Jose Ferreira is the Founder and CEO of Knewton

When the EU formed in 1998, I was the crazy guy in the corner of the pub ranting to all my friends that it would one day come a cropper. Since there seems to be little appetite in Europe to fully integrate and become a "United States of Europe," the risk was high that the EU would inevitably fracture--that a member state would one day have to leave. Now former Fed Chairman Paul Volcker seems to agree. As the EU charter stands, it's unclear how this would occur: the charter has pages upon pages about what it takes to get in, but not a single word about what it takes to get out.

So, under what set of circumstances would a member withdraw? One likely culprit would be a localized recession--like the one happening in Greece right now.

When a recession hits a localized area in America such as, say, Ohio, it might be because the local economy has a dearth of large industries, and those that it does have are suffering. Or perhaps local officials have made a series of poor economic policy choices over a number of years. Often, there's also a larger downturn affecting the entire country or region. In the case of Greece, all of the above is true.

The EU, against its charter, is bailing Greece out. Much has been written about the similarities between the current financial meltdown in Greece and the one that rocked the U.S. at the end of the 2008. America certainly shares some of Greece's weaknesses: bitter partisanship, overly influential interest groups, and a spoiled populace that chronically spends beyond its means.

Nevertheless, the respective crises in America and Greece differ significantly--in ways fundamental to the differences between the U.S. and the EU. When the EU was formed and the Euro was adopted, Euro-cheerleaders applauded the efficiency of a unified market for goods and services (including labor). But economic size confers both plusses and minuses. While there was much back-slapping over the desirable effects of European Union, there was little thought given to the negative consequences.

Under ordinary circumstances, largeness leads to more efficient interstate commerce. It can help make labor markets and capital markets more efficient, so that national resources (workers, federal dollars, etc.) naturally fill vacuums. But smallness has advantages as well. It gives a region control over its currency and interest rates--control that it would lose as part of a larger union.

But the EU has never been anything close to a fully integrated union. And, in practice, the EU confers only some of the benefits of largeness, while taking away all of the benefits of smallness.

In general, fluid labor markets are one of the greatest advantages to largeness--and one of the most important defenses against localized recession. This is the case in America: if there's a localized recession in one place, people leave the region and go where the jobs are. Most Americans don't expect to settle in the town in which they were raised. Sure, there are regional differences, but most Americans can live with trading Dunkin' Donuts for Peet's Coffee, if it means they have a job. Europeans generally don't think this way. There is no central language or culture in Europe. Most Greeks would be astonished if you suggested they move to Dusseldorf.

Capital markets are also generally more efficient in the U.S; money moves around more easily and efficiently, and better fills vacuums where it's needed. So if the rustbelt suffers a downturn, capital might move in because it's a good place to build new manufacturing plants, given all the high-skill, unemployed labor.

Large economies can also prop up underperforming regions with direct government investment. The U.S. government often helps out individual states when they're struggling. In Europe, doing so is illegal; it wouldn't have happened with Greece except for this extraordinary crisis, and it may never happen again.

So the EU lacks some crucial benefits of largeness (at least relative to America). This wouldn't be so bad if the member countries retained the advantages of smallness--but the EU's formation took most of these benefits away too.

Depending on their need, small countries typically have several very powerful tools to affect their economies. They can devalue their currency to make exports more competitive. They can "print more money" (increase the money supply) which will encourage inflation; that can be helpful (if risky) because increasing inflation reduces a country's debts and payables both foreign (government bonds) and domestic (salaries and pensions). Countries can also increase interest rates to attract more foreign investment. Or they can lower interest rates to stimulate manufacturing and business expansion within their borders.

But small countries in the EU can do none of these things, since they control neither their interest rates nor their currency.

Greece is a telling example. When the Greeks joined the EU, they promised to hold their deficit at or below 3% of GDP. It's currently around 14%. Because Greece operates at a deficit, each year it has to borrow money to pay the difference. It's like Europe has its own 30-something child who lives in the basement, doesn't really work, and keeps asking for money. The markets think Greece might default. (It very likely will.) So the markets, quite reasonably, are asking for higher fees to lend Greece money, making it even more difficult for Greece to pay its bills.

Why can't Greece just stop spending? It could, but its debts are so great that it wouldn't be enough. The Greeks could try to grow their way out of debt, as America did in the '90s. But America is a much more diverse, vibrant, and efficient economy. Greece is an economy whose three largest industries are tourism, shipping, and... olive oil?

If Greece controlled its currency, it could start pumping money into the system--increasing inflation and devaluing its debt. This would effectively reduce the salaries and pensions of all Greek workers, including government workers (further improving the deficit) and private sector workers (making Greek businesses temporarily more profitable, and hence improving growth for a couple of years). But Greece doesn't control their currency.

So instead, the rest of Europe is bailing Greece out. They are doing so because they are worried that their own banks own most of that Greek debt. They are also worried about the kind of domino effect we saw in the U.S. with Bear Stearns and then Lehman Brothers. In a crisis, markets always look to see who is the next worst off and proactively begin shying away from them.

But why would Germans, who work harder, save more, and retire later, subsidize lazy irresponsible Greeks? Eighty-eight percent of the German people opposed the bailout plan, and Angela Merkel's government was certain to lose seats in their upcoming election if they supported the bailout. The German people, as we are finding out, aren't quite the suckers we thought they were. Merkel's government supported it nonetheless, and they paid a heavy price at the polls.

Since World War II, the Germans have been devoted to the agenda of fiscal prudence and European stability. Those twin goals had been conjoined; suddenly they are at odds. Apparently, the German governing class had just enough postwar guilt left for one last great effort on behalf of Europe. There won't be another. Europe will have to choose between full integration and inevitable fracture.