What could the leaders of the International Monetary Fund and the European Union have had in mind when they agreed to lend Greece more than $100 billion in exchange for promises to restore stability? After initial relief, markets soon recognized that the program was not sufficient and not likely to be maintained.
When countries joined the common European currency, they gave up the right to use monetary policy to inflate or devalue. That left wage reduction and fiscal restraint as the only recourse in a crisis. With Greece's money wages and government debt too high, the IMF-EU relief effort does not add any new options. Instead it delays default by offering yet more debt as a solution to too much debt, and it gives the Greek government more time to do what it has been unable to do—lower public-sector wages by about 20% and reduce the budget deficit by 10% of GDP.
This only prolongs uncertainty and offers debt-holders a promise by the Greek government that will be hard to honor. No wonder markets are skeptical.
What would have worked? Much of Greece's industry and commerce, including much of the tourist industry, is owned by the state. It should be sold with the proceeds used to reduce public debt. That would make the remainder of the debt more sustainable and transfer workers to the private sector where competitive pressures for lower wages and increased productivity would more closely align employment costs and reality. If the socialist government returned more of the economy to the private sector, Greece would have a better chance of economic recovery.
Much of the Greek economy not owned by the state is "underground," in the so-called informal sector, where wages and incomes adjust quickly to the market. Greece also should offer an amnesty for unpaid back taxes to those who join the legal sector.
If after selling assets the remaining debt is still unsustainable, Greece will have to default (it will be called restructuring, but it is nonetheless default). To lessen the pain from losses borne by Greek and foreign lenders following default, the country should commit to fiscal policies monitored by the European Union. But it should reject the IMF-EU loan. More debt, even subsidized debt, is not the right answer.
The main benefit to Europe of the IMF-EU program is that the Spanish government has agreed to additional reductions in current and future spending. This was a difficult and unpopular political decision given the very high level of unemployment in Spain. A Spanish default would force France and Germany to choose either massive help to Spain or bailing out the losses on Spanish debt at German and French banks. German banks hold $240 billion of Spanish debt but only $43 billion of Greek debt.
Keynesians who think reducing public spending during a recession is a disastrous error should recall that they warned British Prime Minister Margaret Thatcher in 1981 that Britain would never recover if she continued with her tight fiscal and monetary policy during Britain's deep recession. Mrs. Thatcher declined to take their advice. Expectations about Britain's future changed for the better, and a long, productive recovery began soon after.
Greece's government should take heart from her example. The new government in Britain might remember this as well. And so might the Keynesians in the Obama administration.
**Mr. Meltzer is a professor of economics at Carnegie Mellon University, the author of "A History of the Federal Reserve" (University of Chicago Press, 2004), and a visiting scholar at the American Enterprise Institute.
