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Paul Krugman on Europe ‘Doing the Unthinkable’

This week we’re profiling one of the more prolific, public and controversial economists — Paul Krugman. We couldn’t fit everything of interest into one piece, so over the next few days we’re rescuing some of his arguments from the cutting room floor, including his thoughts on the euro crisis and Fed head Ben Bernanke. For the other side, we’re including critiques from critics.

Monday we spotlighted his take on European austerity with a response from Jacob Kirkegaard of the Peterson Institute.

Tuesday features the economist’s view on Spain’s euro-woes and its housing bubble, and what Krugman thinks Germany should do about it (namely, accept a rise in inflation).

Our critical response comes from Terence Burnham, my microeconomics teacher at Harvard’s Kennedy School in the ’90s. He is co-author of “Mean Genes” and sole author of “Mean Markets and Lizard Brains.” He has run a biotechnology firm, been a money manager in Boston, and taught evolutionary biology at Harvard and negotiation at the Harvard Business School. He has now resettled in his native California with his family and teaches finance at Chapman University.

A good idea came in from your comments Monday, so below Burnham’s response we are posting the transcript of the video, for those who would like to read not just the critique, but Krugman’s exchange with NPR’s Tom Ashbrook, which took place at a public event in Cambridge Massachusetts in connection with his new book, “End this Depression Now!”

Response: ‘Don’t Cut the Cat’s Tail Off an Inch at a Time’

Terence Burnham

Paul Krugman seems to be saying very little in this second piece. Let me recap and comment.

Spanish unemployment is 25 percent. You can restate this as: there is an enormous surplus of Spanish workers. Econ 101 tells you that when there is a surplus, the price is too high.

I favor exit. Repudiate all debts, devalue, start over. Spanish wages would fall, but most people would have jobs.
–Terence Burnham

Spanish wages are too high. How will they be lowered? There are options:

  • a) Reduce Spanish wages in euros;
  • b) devalue through a new Spanish currency;
  • c) raise the prices of everything in the world so that real Spanish wages can decline while keeping nominal wages flat (i.e., inflation).
    Terence Burnham

Krugman favors option c. There are two problems with inflation, however:

1) It is very dangerous. The world would have to embark on an incredible round of printing money to get real Spanish wages to be competitive. What would happen? No one knows and we should all be afraid.

Economists are terrible at predicting outcomes in standard times. No one can know what would happen if there were tens of trillions of printing money (“quantitative easing”) throughout the world. When the first atomic bomb was detonated, the scientists thought there was some small chance the bomb would start a chain reaction and blow up the world. Economists are terrible forecasters and the implications of unprecedented quantitative easing are unknowable.

2) It will never happen. The German public will oust Angela Merkel if she attempts an inflationary exit. In this case, the German people are smarter than Nobel-laureate Paul Krugman.

So what will happen? Either grind down nominal wages over years, or exit the euro as Iceland did.

I favor exit. Repudiate all debts, devalue, start over. Spanish wages would fall, but most people would have jobs.

In addition, psychologically it is much better to take your pain all at once. You don’t cut the cat’s tail off an inch at a time.


TRANSCRIPT: ‘The Unthinkable’

Video above.

Tom Ashbrook: You’re talking about, writing about the end of the EU, the end of the common currency.

Paul Krugman: it’s unthinkable except that continuing down the current path is unthinkable. Spain is actually the epicenter. The Spanish government did nothing wrong. Spain was running a budget surplus before the crisis. It had low levels of debt. But it had a monstrous housing bubble, as did a lot of places, largely financed by the way by German banks which were lending to Spanish banks, which then lent on. And when the housing bubble burst you were left with a severe, extremely severe recession, and so the answer has been government austerity which just makes the slump deeper.

The alternatives to a breakup of the euro have to be Europe-wide solutions. And so the solution, if there is one, involves accepting a higher rate of inflation for Europe as a whole and that particularly means higher inflation in Germany.
–Paul Krugman

What are Spain’s alternatives here? Well, if they still had their currency, their own currency, the answer would be devalue, let the peseta drop, Spanish exports would become a lot more competitive, they’d be well on their way to recovery. They don’t have their own currency, so people are saying: Well, you have to do all this stuff to stay within the Euro. At some point you say: Well, you know if your answer to our problem is just ever more suffering, ever more you know… 25 percent, 50 percent youth unemployment. If that’s your notion of a solution, then maybe although it would be a very terrible thing to have the Euro breakup, maybe that’s better than what we’re doing. So that’s becoming a real possibility now.

The alternatives to a breakup of the euro have to be Europe-wide solutions. And so the solution, if there is one, involves accepting a higher rate of inflation for Europe as a whole and that particularly means higher inflation in Germany. Talk to the Germans about this and of course they go crazy, but you have to say to them: What is your answer? What you’re doing right now is just a path to the collapse of the euro with enormous damage and radicalization and a lot of things that you don’t want to see happen in Europe happening.

TA: If the Germans can’t take their foot off the brakes, they’re just intrinsically and against history and everything else, Weimar, if they can’t do it, what happens?

PK: Then Europe breaks up and… No, I mean I think it’s that stark. It really is, it really is that extreme because you know it’s one of those things, you can’t be saying that, but then you say: Well, let’s talk this through. You know, let’s as it said in the original edition of the Godfather – Let us reason together. Right? What are the ways that this can work out? And the current path is not one that can work out.

It’s like an irresistible force hitting an immovable object. On the one hand it’s unthinkable that they’ll allow the euro to fail because the euro is a terribly important thing, it’s not terribly important economically, it would have been better off if they’d, if they had never done it, but now that it has been done, for it to fail is a defeat for the European project, the whole project of bringing peace, democracy, integration to a continent with a terrible history. So it’s unthinkable that they’ll allow it to fail, but it’s also unthinkable that the Germans will accept moderate inflation which is the only solution any of us have been able to come up with. So one of two impossible things is going to happen. Your bet.

This entry is cross-posted on the Rundown– NewsHour’s blog of news and insight.

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