Paul Krugman: One Size Fits None


In today’s Business Insider, Joe Weisenthal reports on Europe’s truly dismal PMIs (survey-based indexes that act as early-warning indicators for official economic data). There’s no doubt at all that the continent is falling deeper into recession, even in the core countries. And reading this news reminds me of something I’ve been meaning to write – namely, that discussions of Europe’s troubles, and the debate over austerity, often suffer from a tendency to blur two somewhat different issues.

One issue – which is the one that gets the most attention – involves the degree of austerity imposed on debtor countries. Clearly, debtor nations have very little choice about going along with the troika’s demands unless they’re willing to abandon the euro – and that’s a line nobody has yet been willing to cross, although Cyprus and the onset of capital controls bring the possibility closer. As for the troika itself, I would argue that enlightened self-interest on their part would call for milder austerity – loosening up by a few percent of GDP would make relatively little difference either to debt dynamics or to the pace of internal devaluation, but could be make or break for the political outlook. But even austerity skeptics would agree that some austerity in these countries is unavoidable; that’s the price of one-size-fits-all monetary policy.

But there’s a separate issue – the status of Europe as a whole. What has happened in Europe is that the peripheral countries have been forced into extreme austerity, but this has not been offset in the core – in fact, core countries have also engaged in austerity measures, albeit not as severe. So the overall result has been a sharp fiscal contraction in Europe – the cyclically adjusted balance is now much tighter than it was before the crisis, even though private-sector demand remains very weak — with no offset from looser monetary policy.

European policy makers seem surprised that this policy mix has led to a double-dip recession, but they have no right to be – it’s exactly what basic macroeconomics would have told you to expect.

And this in turn tells you that the euro is an even more flawed construction than optimum currency area theory might have predicted. OCA emphasized the problem of one size fits all in the face of “asymmetric shocks” – the problem of how countries are supposed to cope if they’re slumping while the rest of the currency area is booming. But it turns out that in times of broad economic weakness this problem is compounded by the asymmetry of the pressures countries face, in which troubled economies are compelled to tighten but less troubled economies feel no need to loosen, so that the overall stance of policy has a strong deflationary bias.

As Matt O’Brien says, this is the same issue countries confronted under the gold standard – a problem they dealt with, eventually, by going off gold.

If European policy makers really want to save the euro, what they should be doing is pushing hard against their system’s deflationary bias. Unfortunately, as far as I can tell they aren’t even willing to acknowledge that the problem exists.

One Size Fits None –

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