Paul Krugman: Lessons From Europe

 Lessons From Europe, by Paul Krugman, in NY Times: Let me return for a minute to Kevin O’Rourke’s recent piece on the European summit. Aside from pointing out just how bad an idea the new super-stability pact is, O’Rourke makes an important observation about what the European experience teaches us about macroeconomics:

One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and is predicting declines in eurozone GDP for late 2011 and early 2012.

A second, related lesson is that it is difficult to cut nominal wages, and that they are certainly not flexible enough to eliminate unemployment. That is true even in a country as flexible, small, and open as Ireland, where unemployment increased last month to 14.5%, emigration notwithstanding, and where tax revenues in November ran 1.6% below target as a result. If the nineteenth-century “internal devaluation” strategy to promote growth by cutting domestic wages and prices is proving so difficult in Ireland, how does the EU expect it to work across the entire eurozone periphery?

The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members’ loss of ability to devalue their exchange rates is a major cost. Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.

Basically, European experience is very consistent with a Keynesian view of the world, and radically inconsistent with various anti-Keynesian notions of expansionary austerity and flexible prices.

The point about nominal wages is especially telling. Ireland has clearly — clearly — faced a massive demand shock; maybe Casey Mulligan will find some way to insist that 14.5 percent of the Irish work force has voluntarily decided to refuse employment, but it’s just not true. And Ireland is supposed to have flexible markets — remember, before the crisis it was hailed as an example of successful structural reform. Yet here’s what has happened to hourly wages in manufacturing in the face of catastrophic unemployment:

It is really, really hard to cut nominal wages, which is why reliance on “internal devaluation” is a recipe for stagnation and disaster.

The crisis really has settled some major issues in economics. Unfortunately, too many people — including many economists — won’t accept the answers.

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