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By Allan H. Meltzer
Professor of Political Economy at the Tepper School, Carnegie Mellon University, and Distinguished Visiting Fellow at the Hoover Institution

On a recent visit to Greece, French President François Hollande declared that Europe's decline was over, and urged French companies to invest in Greece. Bad advice. French production costs are high, but Greek costs are higher. Despite the considerable decline in Greek (and Italian and Spanish) real GDP since 2007, adjustment is far from complete.

In fact, one would be hard pressed to find broad agreement with Hollande's assessment anywhere in Europe. Before the recent Italian election, financial markets showed signs of optimism, encouraged by the European Central Bank's policy of guaranteeing eurozone members' sovereign debt, expanding its balance sheet, and lowering interest rates. Bondholders gain when interest rates fall. But unemployment continues to rise in the heavily indebted southern countries, and output continues to lag behind Germany and other northern European countries.

The main reason for the lag is not simply low demand or large debts. There is a vast difference between unit labor costs - real wages adjusted for productivity - in Germany and in the heavily indebted southern countries. When the crisis began, production costs in Greece were about 30% higher than in Germany, so Greece exported very little and imported very much. Production costs in other heavily indebted countries were 20-25% higher than in Germany.

Growth will not resume until production costs in the indebted countries decline, which requires either a substantial permanent increase in productivity, a reduction in real wages, or both. While some adjustment has occurred, much of the change is not permanent. Austerity reduced the number of employed workers, particularly those with low skill and productivity levels. But gains in measured productivity growth from this source are not permanent changes, so a large part of the reported reductions in unit labor costs are temporary.

Indeed, major cost differences remain. In Greece, the private sector has been forced to adjust, but the government failed to keep its promise to reduce public employment. That will prolong excessive government spending, and deficit targets will not be met on a sustained basis. Large reductions in public-sector wages brought down the primary deficit, but employment maintenance lowers productivity, raises costs, and delays adjustment.

In Italy, former Prime Minister Mario Monti's government undertook some reforms, but it continued to support unions and corporate monopolies. And Italy's parliament rejected many of Monti's proposed reductions in government spending. Labor and many product markets remain closed, despite the urgent need to increase competition, lower production costs, and raise productivity.

After five years of slow growth and rising unemployment, voters in other indebted countries, like Italians (and French voters before them), are likely to reject additional spending reductions, tax increases, and further painful deregulation. Europe must find more effective policies that reduce production costs toward German levels.

The economic historian Harold James has shown in a recent book that in the 40 years of negotiations leading to the adoption of the common currency, all of the problems that now beset the eurozone were discussed repeatedly. Everyone understood that a monetary union would require enforceable fiscal and banking rules. But such rules were never adopted.

Before the euro, countries adjusted misaligned production costs by devaluing or revaluing their exchange rates. Fiscal austerity is a poor substitute. It works slowly, if at all, because elected governments are often reluctant to implement their promises - and may not feel bound by those of previous administrations (especially if they owe their victory to voters who are rebelling against years of belt-tightening with no evidence of renewed growth). Likewise, politicians are reluctant to adopt deregulation that eliminates state-sponsored special privileges.

For several years, I have proposed a policy that combines growth and fiscal rectitude. Let all the heavily indebted southern European countries jointly agree to join a weak euro, which would float against the stronger northern euro. When the weak euro reduces the heavily indebted countries' production costs by 20-25%, they can rejoin the "hard" euro if they accept fiscal reforms that are subject to approval by the European Commission (and thus by the hard-euro creditor countries). After all, a fixed exchange rate or common currency requires limits on fiscal independence.

The Italian election sent a message. After five years of decline in living standards, voters oppose more austerity and further retrenchment without growth. Restoring a sound euro requires policies that revive growth, rein in government spending, and reform heavily regulated labor and product markets.

Copyrights: Project Syndicate