The Greek crisis in a nutshellShackled to the euro and reluctant to reform, its exports are uncompetitive.

By Steven Gjerstad and Vernon L. Smith 27/4/15, 8:26 AM CET Updated 27/4/15, 8:58 AM CET

When a small-to medium-sized national economy suffers a collapse following an outsized real estate and investment boom, the economy is plunged into deep recession with the balance sheets of many households, firms and their banks suffering reduced or negative equity. The economy is overvalued relative to the world economy, and there soon follows — in spite of any support effort by their central bank — a sharp market depreciation of its currency that quickly re-aligns the country’s cost, wage and price structure with the world economy. The process of economic recovery then begins: net exports — cheap to the world economy — start to surge; domestic industry, insofar as it faces import competition, is advantaged; output grows with the increased demand. And with the resumption of its competitiveness in the world economy, the economy gradually recovers.

Integrated with a diverse group of other countries by the common euro, this traumatic but effective market adjustment process could not occur in Greece. Even more painful than the process just described, the Greek economy and government have been struggling on economic life-support transfusions for over five years. Greek GDP peaked eight years ago and remains more than 25 percent below peak. Bailout funds, loan extensions, and principal reductions, administered through political processes, have failed abysmally to revive the Greek economy or resolve the fiscal mess.

The sense that the Greek economy is not competitive in international markets is widespread. But to know the extent of that lack of competiveness, we need a way to measure it; and to assess how much the lack of competitiveness contributes to the Greek dilemma, we need to compare Greece to countries that were in a comparable situation five years ago.

As we have indicated, most deep economic crises involve a shift from rapid growth of fixed investments, especially real estate, to growth of exports. Some European or EU economies, such as Estonia and Ireland, have made this difficult transition effectively, even within the common currency union. Others, such as Greece and Italy, have not.

Competitiveness on international markets is a clear factor in the extent of recovery for the economies of the European periphery. In 2014, Greek GDP was 26 percent below its 2007 level. In a pattern that is quite common among serious downturns, fixed investment expenditures accounted for 65 percent of the decline in Greek GDP. Unlike most of these deep downturns, export growth has not supported a recovery. Greek exports were 1 percent lower in 2014 than in 2007.

Estonia provides an illustrative contrast. Estonian GDP, which had fallen 21 percent at the end of 2009 from its peak two years earlier, is now only 1.8 percent below its peak. When Estonian

GDP hit bottom, the decline in fixed investment accounted for 91 percent of the downturn. But Estonian exports in 2014 were 39 percent higher than in 2007.

The comparison between Italy and Ireland is similar. Italian GDP was lower in 2014 than in any year since 2007; it is now 9 percent below its peak level. The decline in fixed investment amounted to over 70 percent of the decline, comparable to the impact of Greek and Estonian fixed investment declines. But exports have provided no boost. In 2014 Italian exports were 1 percent below their 2007 level. By contrast, Ireland’s GDP, which fell 11 percent from 2007 to 2009, is now only 1.5 percent below its peak annual level. As in Estonia, Irish exports have grown rapidly over the past seven years, and are now 32 percent higher than they were in 2007.

Deep economic downturns almost always result from an unsustainable increase in investment in fixed assets. Recovery from them almost always involves a reorientation from building booms to export booms. The recovery depends on the restoration of competitive labour market conditions.

In the absence of independent currencies, and market depreciation to facilitate the return to competitiveness, Greece, Italy, Spain and Portugal all need political economy reforms that reduce the costs of exporting firms and increase their competitiveness on international markets. This has been the key driver of recovery and growth in a dozen or more economic crises and restructuring events around the world that we have examined in our book, Rethinking Housing Bubbles, published in 2014.

If Greece defaults on its debts, which seems likely, if not inevitable, then it will have no alternative but to face up to the urgent need to reform and reduce its labour and cost structure to restore its competitiveness in international markets.

Steven Gjerstad is a presidential fellow at Chapman University in Orange, Calif. Vernon Smith is a professor of economics, finance and law at Chapman and a 2002 Nobel laureate in economics.