Like most investors I spent most of last week addicted to news about the crisis in the Eurozone. I have assiduously followed the progress of the European summit together with the market reaction. After extensive emersion in every newspaper, magazine, radio program and television show my conclusion is that I have totally wasted a week. Little if anything was accomplished. The reason is quite simple. The Europeans are trying to solve the wrong problem. What they should do is to learn from US history. They didn’t and it will cost them and everyone else.

 The most recent agreement is based on the idea that fiscal malfeasance is the origin of the crisis. The thesis goes something like this. Wicked spendthrift governments mostly in Europe’s periphery borrowed a lot of money and blew it on social programs. Now they can’t pay the money back.

 To solve this problem the summit decreed penitence. All Eurozone countries would be forced to adopt budgetary discipline through a “fiscal compact”. They would also pass ‘golden rules’ to ensure balanced budgets. If the rules were broken, they would be punished with automatic penalties. They also added a few Euros to the bailout fund, but much of the fund depends on leverage and anyway it wasn’t enough.

 This approach was politically acceptable but has some definite problems. The first is that a recession is the wrong time to adopt an austerity package. Austerity creates a vicious circle of economic decline. It reduces domestic demand which raises unemployment and lowers revenues from taxes. This in turn creates larger deficits which lessens confidence in banks and shaky sovereign debt. Besides it isn’t the problem.

 Before the crisis Spain, Estonia and Ireland had much better control of their deficits than Germany, Austria or France. They were in fact running a surplus. As a result of their fiscal discipline Estonia, Ireland and Spain has much better control of their public debt than Germany and France. Although Greece and Italy’s public debt is over 100% of their GDP, Spain’s debt is only slightly more that Germany or Austria’s. Estonia and Finland have surpluses.

 The real problem was competitiveness. The Eurozone countries that got into trouble, Estonia, Portugal, Greece, Spain, Ireland and Italy were all running substantial trade deficits. Estonia’s current account deficit was over 10% of GDP. So when the crisis hit in 2008 and private financing of the external imbalance dried up, the countries were in deep trouble.

 Estonia is sort of the poster child for the problems of the lack of competitiveness and what to do about it. Estonia is a tiny country and its banking system is owned by foreign firms, mostly from Sweden. During a construction boom, Estonia’s growth was at double digits. After the crash it fell by 14%. The result was pain. Employment rocketed to 18%.

 One tried and tested way to increase competitiveness is to devalue your currency. The Chinese are especially good at keeping the yuan low in order to insure their competitiveness. But since Estonia like Italy and Greece is a member of the Eurozone, this option was not available. Instead they went through an internal devaluation, which included slashing 9% of GDP from their budget and big cuts in nominal wages. The medicine worked. Estonia now has surpluses and its growth rate at 8.5% is the highest in Europe.

But Estonia had something else that was very important. It had a regulatory framework that encouraged business and was fairly clean. On the Doing Business Index and Corruption Index it scores slightly below Germany. In contrast Italy’s business climate is worse than Mongolia’s and Greece is worse than Yemen. As to corruption both countries are worse than Rwanda.

 One thing that the Eurozone could do would be to create a form of joint liability like Eurobonds. These could be adopted with a credible sanction. Any country that spent too much couldn’t use them.

 The success of this method was proved over 200 years ago in the United States. In 1790 the recently created country had a massive war debt of $54 million or about $4 trillion in today’s money. The problem was that the debt was very unequal. Some states like New York were deeply in debt, while others like Virginia were almost debt free. One of the country’s “founding fathers”, Alexander Hamilton had an idea. The new United States federal government would assume all the debt and create joint liability of US bonds.

 Hamilton’s plan was an incredible success, but sadly no such solution was agreed to by the European summit. This desire to punish rather than cooperate insures that the ongoing crisis continues and continues to get worse. Credit remains tight, capital flight from the Eurozone is becoming a real problem and Standard and Poor’s will most likely downgrade several member states. So don’t expect a happy New Year anywhere.