The Greek economy needs to raise its income if it is to repay its debts.  The austerity measures being forced on Greece will further starve it of the income it needs to employ its people and pay its way.  Greece needs prosperity, not austerity. 

It is Europe’s monetary system that is constraining the Greek economy from earning the income it needs.  Associated with that constraint are two growing burdens: domestic debt and foreign debt. Modifying the monetary system can painlessly remove the constraint on income and the associated debt burdens,  enabling the Greek economy to prosper.

For example, China's monetary system allows its economy to prosper from its foreign and domestic trade.  But Europe's system does not.  Europe’s monetary policy prevents its exports from stimulating its economy.   If exports rise in one part of Europe, the value of the Euro must rise to reduce exports from other parts.  The higher Euro also makes imports cheaper, so people buy less European products and more foreign imports.  This monetary constraint, therefore, is starving the whole European economy of income, not just Greece.   

Under the current European monetary system, the only source of additional money available to stimulate the economy is from bank credit.  However, that source of money is not income and it does not sustain the economy.  It enlarges the burden of domestic debt.   

People earn money from selling what they have produced. When they spend that money, they are buying the equivalent of what they have produced.  If people spent only the money they earned, they would be buying goods equal in value to those they had produced.  Bank credit provides additional money to the economy to buy more goods.  It enables people to spend more than they have earned and, therefore, buy more than they have produced.   

The only way an economy can buy more than it has produced is to import more than it has exported.  To pay for those additional imports, the economy must borrow.  That borrowing enlarges the burden of foreign debt. 

The economy is obliged to service two debt burdens with interest payments and loan repayments. These debt servicing payments reduce the amount of money available to be spent on the productive side of the economy.  As a result, production in the economy grows at a slower rate than its debts.  If effective action is not taken, the debt burdens will grow so large that the servicing costs overwhelm and destroy the Greek economy.  

Any solution to Greece’s economic problems, and therefore a recipe for prosperity,  must deal with both the lack of income and the debt burdens.  The optimum exchange rate system is a two part monetary system capable of reducing the burden of debt and nourishing the economy with income from domestic and international trade.

The first part of the system regulates the amount banks may lend according to the reduction in their foreign debt.  For example, banks may be permitted to lend one additional Euro for every two dollars they reduce their foreign debt.  Such a policy raises the amount of money in the economy but reduces the money required for debt servicing, leaving more money available to be spent on the productive side of the economy. 

The second part of the system injects money into the economy from export income.  It uses banking guidelines to provide rewards to the banks for achieving the government’s employment and inflation targets.  For example, the guidelines may reward the banks with increased lending capacity (and profits) if unemployment is reduced to, say, 4 per cent and inflation is kept below 3 per cent.  

In response to the incentives, banks would push down the exchange rate.  The lower exchange rate would raise export incomes.  Also, the lower exchange rate would raise the price of imports, thereby making domestic products relatively cheaper.  People would shift their spending from the expensive imports to the cheaper domestic products.  That would boost domestic incomes and generate additional employment. 

Also, in response to the rewards provided in the banking guidelines, the banks would manage their foreign exchange and lending activities to ensure that the economy met the government’s target for inflation.    

The optimum exchange rate system provides Greece with a remedy for its economic problems.  It would allow it to lower its exchange rate, raise exports and buy more products from Greece. 

If the other Euro countries were not prepared to accept the necessary reforms to the monetary system, Greece could establish its own currency and adopt the optimum exchange rate system. 

The increased prosperity generated by these reforms would raise government revenue and enable it to repay its debts.  This remedy would not only be painless, it would rejuvenate the Greek economy, providing employment and raising incomes.     

 

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Formula for the current account balance explains mathematically and diagrammatically how the current account balance is determined.  An understanding of the causes of the current account deficit is essential to understanding the causes of Europe's economic problems.

Saving the Euro (pdf) provides a detailed analysis of the issues raised here.

Last update 27 April 2012.