Paul Krugman: The Road to Economic Crisis Is Paved With Euros
PK:
The Road to Economic Crisis Is Paved With Euros: the classic argument for flexible exchange rates was made by none other than Milton Friedman.... [T]here are obviously benefits from a currency union. It’s just that there’s a downside, too: by giving up its own currency, a country also gives up economic flexibility. Imagine that you’re a country that... recently saw wages and prices driven up by a housing boom, which then went bust. Now you need to get those costs back down. But getting wages and prices to fall is tough: nobody wants to be the first to take a pay cut.... If you still have your own currency, however, you wouldn’t have to go through the protracted pain of cutting wages: you could just devalue your currency — reduce its value in terms of other currencies — and you would effect a de facto wage cut.
Won’t workers reject de facto wage cuts via devaluation just as much as explicit cuts in their paychecks? Historical experience says no....
Why the difference? Back in 1953, Milton Friedman offered an analogy: daylight saving time. It makes a lot of sense for businesses to open later during the winter months, yet it’s hard for any individual business to change its hours: if you operate from 10 to 6 when everyone else is operating 9 to 5, you’ll be out of sync. By requiring that everyone shift clocks back in the fall and forward in the spring, daylight saving time obviates this coordination problem. Similarly, Friedman argued, adjusting your currency’s value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts.
So while there are benefits of a common currency, there are also important potential advantages to keeping your own currency. And the terms of this trade-off depend on underlying conditions....
Climate, scenery and history aside, the nation of Ireland and the state of Nevada have much in common. Both are small economies of a few million people highly dependent on selling goods and services to their neighbors. (Nevada’s neighbors are other U.S. states, Ireland’s other European nations, but the economic implications are much the same.) Both were boom economies for most of the past decade. Both had huge housing bubbles, which burst painfully. Both are now suffering roughly 14 percent unemployment. And both are members of larger currency unions: Ireland is part of the euro zone, Nevada part of the dollar zone, otherwise known as the United States of America.
But Nevada’s situation is much less desperate than Ireland’s.
First of all, the fiscal side of the crisis is less serious in Nevada... much of the spending Nevada residents depend on comes from federal, not state, programs.... Nevada, unlike Ireland, doesn’t have to worry about the cost of bank bailouts, not because the state has avoided large loan losses but because those losses, for the most part, aren’t Nevada’s problem. Thus Nevada accounts for a disproportionate share of the losses incurred by Fannie Mae and Freddie Mac, the government-sponsored mortgage companies — losses that, like Social Security and Medicare payments, will be covered by Washington, not Carson City. And there’s one more advantage to being a U.S. state: it’s likely that Nevada’s unemployment problem will be greatly alleviated over the next few years by out-migration.... Over all, then, even as both Ireland and Nevada have been especially hard-luck cases within their respective currency zones, Nevada’s medium-term prospects look much better.
What does this have to do with the case for or against the euro? Well, when the single European currency was first proposed, an obvious question was whether it would work as well as the dollar does here in America. And the answer, clearly, was no.... U.S.-based economists had long emphasized the importance of certain preconditions for currency union.... Robert Mundell of Columbia stressed the importance of labor mobility, while Peter Kenen, my colleague at Princeton, emphasized the importance of fiscal integration....
These observations aren’t new: everything I’ve just said was well known by 1992, when the Maastricht Treaty set the euro project in motion. So why did the project proceed? Because the idea of the euro had gripped the imagination of European elites. Except in Britain, where Gordon Brown persuaded Tony Blair not to join, political leaders throughout Europe were caught up in the romance of the project, to such an extent that anyone who expressed skepticism was considered outside the mainstream.
