Krugman on Europe

Paul Krugman’s article in today’s NYT  describes his perspective on the European situation.  His main focus is on thedifficulty in European-level policy coordination, in view of the current institutional configuration. However, he also flags the adjustment difficulties facing Spain (largely similar to those facing Ireland):

“In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.”

It is interesting to note that Krugman accepts the thesis that wage cuts are required as part of regional adjustment within the euro area (indeed, he has signalled this on his blog in the past).  For Ireland, the level of pain may be lower than in Spain,  in view of the relative flexibility in the labour market and the potential for the social partners to contribute a pain-reducing level of coordination to the wage adjustment process as part of an overall reform package. However, a slow rate of adjustment will lead to a prolonged period of high unemployment.  In addition, the slower the rate of economic recovery, the worse will be the fiscal situation.

8 replies on “Krugman on Europe”

Would I be very wrong in saying that the diff between wage cuts and devaluation is mostly political? I mean if we (could have) devalued, then imports would be more expensive and so real incomes would fall anyway, no? So wage cuts are just a more direct route? I’ve a feeling I’m missing something. Is Krugman saying that the problem with wage cuts is really that they’re hard to implement, rather than that they’re ineffective?

Marcus, I echo your question.

Isn’t the thing about devaluation that it applies automatically to all but that a wage cut needs alot more work to make sure it will hit all. Work that may or may not be done.

I’d like to see the linear fit for data prior to 1.1.2002 and post. I bet it would bolster the long held suspicions among Spaniards that the euro was an aid to price inflation.

“It is interesting to note that Krugman accepts the thesis that wage cuts are required as part of regional adjustment within the euro area (indeed, he has signalled this on his blog in the past).”

Why would this be interesting? It’s obvious that (some) wage rates have to fall if we are to prevent mass unemployment on an unimaginable scale. All Krugman is doing is advocating a monetary charade in order to get it done.

I also find it funny that a direct fall in nominal wages is described “painful” and “grinding”, while the debasement of currency isn’t.

Philip,
If Krugman accepts the wage cuts thesis, it has to be said that he does so (in this article at least) with reluctance and more than a hint of agnosticism: “This process (wage cuts) would have been difficult at the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending towards deflation for years to come.”
Indeed, there is an agnostic thread running through the entire piece. At one point he offers the judgement that “Europe’s economic and monetary integration has run too far ahead of its political institutions”. And at the end, he delivers something rather less than a ringing endorsement of the euro (and its sustainability?): “Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe. But Europe can still prove the sceptics wrong if its politicians start showing more leadership. Will they?”
Methinks the great Krugman is firmly in the sceptical camp himself.

At the risk of overkill on my pet proposal for a notional defined contribution pension system add-on (link below), it seems worthwhile to consider one bit of additional fiscal engineering motivated by Philip’s post. The NDC add-on could be useful device for bringing about a synchronised reduction in nominal wages.

I have argued that the original proposal has the merit of bringing a temporary but long-lasting flow of new revenue to the exchequer, without imposing a significant burden on household wealth (here expected lifetime income), and without a significant rise in marginal tax rates. It also provides a needed strengthening of the retirement income system.

Suppose, however, that achieving improvied competitiveness is deemed even more important than raising revenue (a debatable proposition given the combined fiscal and employment crisis). Instead of adding to total revenue and reducing the deficit, the new revenues could fund a cut in employer PRSI contributions. (An X percent contribution rate to NDC accounts could fund an X percentage point reduction in the employer PRSI contribution rate, since neither is subject to an earnings ceiling and each is levied on the same base.)

From the employer’s perspective, this is equivalent to an X percent reduction in the nominal (and real product) wage. The government does not lose net revenue. And households receive a valuable pension asset in return for their contributions. The improved competitiveness should boost employment (especially with a global recovery) leading to second-round household and fiscal gains.

One obvious obstacle is that a well-designed NDC system requires careful planning and will take time (even drawing on best practice from Sweden and elsewhere). But the economy needs to regain competitiveness as soon as possible. However, with a firm commitment to compensate for the lost PRSI revenue stream out of the new NDC stream, it might be feasible to implement the employer PRSI contribution rate cut immediately.

[The original proposal can be read here: http://www.irisheconomy.ie/index.php/2009/01/27/a-not-so-modest-proposal/:

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