The problem faced by Portugal, Italy, Ireland, Greece and Spain (the PIIGS) is reminiscent of the problem faced by many countries in the early 1930s. At the start of the Great Depression, demand had fallen, deflation was taking hold and trade was drying up. Governments and central banks looked for solutions.
Back then, most of the major world economies were on the gold standard. They all had fixed exchange rates between their currencies and gold.
Under that system, gold flowed out of countries experiencing inflation or trade deficits and in to countries experiencing deflation or surpluses. To protect their gold, countries would implement deflationary policies by raising interest rates and reducing the money supply.
To make the economy function at the lower price level, they also had to achieve wage deflation. That proved difficult because increasing labor organization and structured wage settlements had made wages more sticky. Unemployment started rising. Meanwhile, increasing deflation led to higher real interest rates and higher real debt obligations.
Today, the PIIGS face the same imperative to deflate because their economies are generally uncompetitive. There are differences between them, and perhaps Ireland is best placed, but as a group they are uncompetitive. As with the gold standard countries, their output has to be delivered to customers at a more competitive price. In both cases, devaluing the currency (external devaluation) was not, and is not, an immediate option, so wage deflation (internal devaluation) is the only way forward.
At the same time they are battling problems with government deficits. The gold standard countries were constrained in the fiscal support that they could give their economies. Government spending only counteracted the deflationary policies they were trying to implement. For the PIIGS, reducing deficits is a matter of necessity, forced on them by threats from the markets and Brussels. But this fiscal restraint will make other aspects of their task harder.
Reductions in domestic government spending, and increases in tax and interest payments, will put further pressure on private saving. This may make domestic investment funding harder to obtain. At the same time, it will be difficult to attract international investment funds, due to the increased risk premium that will be required.
But if they can't attract investment, then it will be difficult to improve productivity, and so competitiveness may decline further. This is a recipe for reduced output and higher unemployment, leading to further pressure on government deficits.
Meanwhile, deflation and real interest rates will keep increasing. I hope they can show the world that it is possible to make progress by deflating, but we have to be realistic. They are being asked to do something that the world collectively failed to do in the Great Depression. Not only that, they are starting from a worse position than many countries were in the 1930s and are not at all used to responding to crises with austerity.
The easy way out for the PIIGS would be the same as for the gold standard countries in the 1930s i.e. to devalue. The UK and all of the Scandinavian countries devalued in 1931. Others, including Greece, followed in '32, and the US in '33. Some, such as France, Italy and the Netherlands held out until 1936. The evidence (e.g. Bernanke and James, 1991) clearly shows that the countries that devalued first suffered the least. Countries that devalued last had even worse growth rates than the US.
Some of this external devaluation would work for the PIIGS today too, but that would be difficult to achieve. External devaluation for the PIIGS would mean leaving the euro and that would have major ramifications. Aside from the political and legal issues, there would be enormous practical obstacles to overcome. Eichengreen has written that due to these practical obstacles and the inevitability of resulting bank runs, exit from the euro is "effectively impossible".
He is right about the difficulties, but as the world crisis develops, we may start seeing six impossible things before breakfast.
Despite Eichengreen's objections, leaving the euro may still be the best option, both for the PIIGS and the hard core of eurozone countries that would remain. Really, what other options are there?
As I described above, struggling on with internal devaluation is likely to be a losing battle. Bailouts by the EU or IMF only perpetuate moral hazard and address none of the underlying issues. Only long term agreements for northern Europe to subsidize Club Med can address the issues via a fiscal route and, in Europe, no such agreement will happen quickly. Debt default would also do nothing to improve competitiveness, but would throw bond, inter-bank and other investment markets in to chaos. There would be a high risk of contagion to other European countries, and a sovereign version of the Lehman Brothers debacle could easily occur.
Exit from the euro carries similar risks, partly because it would have to be accompanied by debt being rescheduled in local currency. But, if we are going to have a crisis anyway, it would be better to have it in the context of an exit from the euro.
There are no good solutions and no easy answers. I wish these countries well, but because of these difficulties, I can only see a crisis forcing a resolution one way or another. It is likely that there will be a temporary solution which delays the inevitable, but the fundamental problems will remain. If the problems are papered over, the resulting crisis may be more intense.
When the crisis occurs, events will not be contained within the PIIGS, or even Europe. US banks and markets will inevitably be affected by the upheaval. The dollar and US Treasuries would probably be the main beneficiaries, albeit temporarily, as in the crisis of 2008. Precious metals will have to compete with a strengthening dollar. Everything else will be hit hard. In a sports comparison with other financial crises, this one may end up competing for gold.
Disclosure: The author owns no assets in Portugal, Italy, Ireland, Greece or Spain. The author owns precious metals and various dollar assets including Treasuries.