Arnold Kling  

European Monetary and Fiscal Crises

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The Best Policy for the Sovere... Rogoff vs. Kling...

Sebastian Mallaby and Paul Krugman explain that the PIIGS have monetary as well as fiscal problems. That is, their wages are too high, and there is not enough labor mobility to produce the needed adjustment (hence, as many economists argued, Europe is not an optimal currency area). Mallaby writes,


But a eurozone member that allows wages to rise unsustainably has no such easy exit. It cannot regain its competitiveness by the usual trick of devaluing its currency because it no longer has its own currency...

what happens when an indebted country tries to become competitive by forcing wages down? Falling wages means deflation, and deflation increases the burden of those debts -- if you owe a bundle on your credit card and your wages take a sudden hit, you will struggle to make your next payment. Because of this debt-deflation pincer, uncompetitive and indebted countries must choose between default and leaving the euro.

Krugman writes,

The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro, the governments of Greece, Portugal and Spain denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.

I want to push back against both Mallaby and Krugman. Suppose Greece had not been on the euro, and Greece had run the same sorts of budget deficits. Assuming that Greece had borrowed in drachmas, yes, they could have devalued the drachma, which would have both cushioned the drop in demand from fiscal tightening (I'm playing by Keynesian rules in this post) and deflated away some of their debt. On the other hand, if Greece had borrowed in euros (or francs or marks), then they would face the very debt-deflation pincer to which Mallaby refers. In that case, devaluation would raise the cost of their debt.

One cannot just brush aside the fiscal profligacy issues.

Moreover, there is one policy that would address both the fiscal problem and the monetary problem: cut public sector wages by, say, ten percent until the crisis blows over. This clearly helps the fiscal problem. In addition, it makes it easier for the private sector to cut wages, which eases the monetary problem.

And yes, Nick Rowe and Scott Sumner, it probably would help if the european monetary authority would print more euros.



COMMENTS (11 to date)
Ignacio writes:

I am not an economist, but I would imagine that in the case of Grece never having adopted the Euro and devaluating when they had borrowed in such currency, although devaluation would raise the cost of the debt in drachmas, Greek products would be more cometitive in international markets. This is because of lower labor costs and the costs of other Greek inputs valued in drachmas. And anything exported from Greece would still be paid in convertible currency (Euros or dollars). Thus, in such situation Greece would increase their exports and be in a better position to pay for their debts, even if the cost of such debts is higher in drachmas. Am I mistaken?

Jaap writes:

through the adoption of the euro Greece was able to borrow at rock-bottom levels, as it was deemed safe from default.
remember that Greece has been in default half its national life. without the euro their borrowing rates would've been a lot higher. not as high as the last few days, but definitely higher than what it was the past, say, 10 years.
this might be comparable to the subprime crisis. yield-seekers accepted rates below sensible risk-premiums.
yes, it would've been better to borrow in drachmes, but the rates would've been higher naturally.

floccina writes:

I think that one part of the problem is people feel different about their own countrymen than they do about foreigners. We have a little more love for Californians than Germans have for Greeks.

Fundman writes:

Did Sumner and Rowe really advocate inflation as a way out of this? Well I guess it would "help" if they printed more Euros kind of like it would help a drunk by opening up the bars earlier. Currency debasement = helping? We live in a strange world.

Philo writes:

"[I]t probably would help if the european monetary authority would print more euros." Only "probably"? Isn't it *obvious* that relative inflation would help debtors repay their creditors?

david writes:

I think Jaap's got it right. The euro enabled fiscal profligacy by making higher PIIGs deficits sustainable for longer. The market would have bailed on drachma-denominated debt long before now, thus raising yields and discouraging profligacy. Greece might ultimately have defaulted in any case, as it has been wont to do on a regular basis, but it would have defaulted on a (probably much?) smaller amount.

The advantage, I suppose, from an economic perspective, of not being able to devalue (short of leaving the monetary union) is that it forces Greece to deal in some manner with those policies (i.e., the welfare state, strong unions) that simultaneously make what might be naturally sticky prices much much stickier and reduce productivity. Unpleasant, but, as so often the case with reality, inevitable.

The other point which doesn't seem to be geting much air time lately is the other reason why the Eurozone is not an optimal currency area - vastly different political and economic cultures. The sustainability of the euro is based to some degree on states following rules and exercising self-discipline. This is a heroic assumption at the best of times but when one or more states has corruption problems, as Greece is reputed to, and others are, relatively speaking, boy scouts, well, perhaps it's a surprise that things have held together as long as they have.

Yancey Ward writes:
One cannot just brush aside the fiscal profligacy issues

Ah, but this is precisely what they want to do.

jeff writes:

The Greek deficit is 13 or 14 percent of GDP, but not all of that is structural. If Greece follows Arnold's suggestion and cuts public sector salaries and transfer payments by 10 percent, and in addition defaults on its debt, it pretty much closes the gap. It won't be able to borrow any more, at least for a while, but it shouldn't need to.

You still have the problem that Greek costs are not competitive in the Euro area, but the only way to get out of that is to drop the Euro. But if much private Greek borrowing was done in Euros, the depreciation medicine may be worse than the disease.

So they might as well stay on the Euro, but default on goverment debt. The big losers in that scenario are the European banks that hold the Greek debt, but just why the Greek government should care about them is beyond me.

A few sovereign defaults just might raise borrowing costs for other governments enough to slow their spending. Milton Friedman never tired of pointing out that the cost of government is how much it spends, not how much it taxes. Slowing spending by increasing sovereign risk premia is a good thing.

Pete writes:

What percent of public sector budgets is employee wages in America or Greece?

Tom Grey writes:

I think Greek default might be the best option, but it's not clear what then happens ...
the gov't stops paying out?

That sounds good.
The gov't unions hold strikes? sounds bad.
Martial law? A takeover by militants?
If the Greeks can't print their own Euros, how about them printing new "coupons" good for food (only) with a value denominated in Euros? Vouchers which the gov't will accept in tax payments.

... an alternate, competing currency, which is likely to soon be devalued, but would keep economic activity going thru the transition.


Another wild idea -- Greeks could lease out an island (Corfu?) or two for 89 years to the EU, to cover a couple of years now, but with the EU agency to replace Greek gov't officials on that island. (And hopefully turning such island into a Hong Kong type free market source of production.)

Philo writes:

"[T]heir [the PIIGS's] wages are too high . . . ." Isn't it also obvious that a little inflation would cure that "problem"? The ECB, with its constrictive monetary policy, is needlessly provoking these national financial crises.

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