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Paul Krugman and the Euro

e21 | November 28, 2011

The looming potential collapse of Euro countries has brought increasing scrutiny over the merits of the European Welfare state and the future of a common monetary union. For Paul Krugman, a fan of the European welfare model, this presents a problem. While he granted enormous credence to the idea that bank failures in 2008 amounted to an indictment of the entire philosophy of free-market economics, he now refuses to see the current European problems as reflecting anything deeper about the sustainability of European economies:

What a tragedy. A rich, productive continent, which has produced arguably the most decent societies in human history, is tearing itself apart because its elite insisted on embarking on a dubious monetary project, and now can’t bring itself to take the steps necessary to give that project a chance of working.

That is, Paul Krugman insists that the European debt crisis has nothing to do with excessive government spending.  The problem, to him, is a failed monetary experiment that deprives nations like Greece and Italy of the ability to print money to inflate away excessive debts.  The need to create an alternative understanding for the origins of the debt crisis is only natural given the extent to which the current crisis has tarnished the statist ideology that Krugman generally follows.  But his basic claims are nonsensical, as is Krugman’s citation of Sweden and Germany as economic role models.  While these economies have performed relatively well through the crisis, it was because they abandoned Krugman’s preferred economics and moved in a more market-oriented direction long-ago. 

Krugman argues “since Euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t.”   As e21 explained in a December 2010 editorial, Italy’s experience printing money to confront a crisis was a total disaster:

Between 1974 and 1976, the Italian central bank printed lira in mass quantities to buy Italian government debt. This “large scale asset purchase” program led to a more than 100% increase in the monetary base... The Italian central bank accelerated its money printing in conjunction with a “large fiscal reflation” package adopted in August 1975…

Although the stimulus and money printing succeeded in generating positive growth in 1976, it also precipitated a crisis in the lira. Mario Monti, later competition commissioner of the European Union [and current prime minister], predicted the crisis in late 1975 based purely on observed growth in base money. Foreign creditors – responsible for financing 7.2% of GDP in domestic Italian borrowing during 1973-76 – fled Italian securities causing the value of the lira to fall by 35% in less than five months. Less than two years after the last crisis, the Italian financial system was again embroiled in a panic as printing money to accommodate spending in excess of income at both the government and national levels widened current account deficits and triggered a foreign investor revolt.

Krugman may prefer currency debasement and economic chaos to cuts in social welfare spending, but that’s because he is approaching these issues from the left or progressive angle, not because that is a particularly rational choice that most educated electorates would willingly pursue.  Indeed, these crises so scarred Italy that it helped motivate Euro membership.

Secondly, Krugman argues that “nations now in crisis don’t have bigger welfare states than the nations doing well” and cites Sweden and Germany as examples.  As e21 explained in a May 2011 editorial, Germany and Sweden were the star performers of 2010-2011 precisely because they chose to…

tolerate large temporary deficits as the result of automatic stabilizers and the decline in tax receipts, but ensure that the numbers add up over the course of the budget window… The German budget finished 2010 with a budget deficit equal to 3.3% of GDP after running a surplus in 2008 and a 3.3% of GDP deficit in 2009. The 2011 deficit is expected to decline to 2.5% of GDP, or about one-fourth of the U.S. deficit. The Swedish budget was in balance in 2010 after a 0.8% of GDP deficit in 2009, despite a 5.1% contraction of the economy…The endurance of Sweden and Germany’s social model is a function of broad-based taxes on consumption that tend to be regressive, but reliably generate revenue.

Germany and Sweden ran very small deficits during the worst of the crisis and avoided the kind of wasteful discretionary stimulus Krugman was urging.  Although Sweden has a large government, it has fallen in size by 17% since the mid-1990s.  Indeed, Sweden is a perfect example of a government that had grown too large and an economy too reliant on currency depreciation to restore competitiveness.  Indeed, Sweden’s “expansion through austerity” experience of the early 1990s was probably the clearest renunciation of Krugman’s preferred policy approach.  Now he wants to cite Sweden as a foil to Italy simply because it has a large government.  Again, as explained in the e21 editorial, countries could only maintain expensive welfare states if they relied heavily on consumption taxes, maintained balanced budgets, and avoided fiscal stimulus:  

Since the 1980s, the Swedes have recognized the threat fiscal incontinence poses to the generosity of benefits. Eventually, deficits of sufficient size put the welfare state itself on the chopping block. The best way to protect their cherished model is to keep the budget near balance so these types of existential questions are never asked.

It is not clear that Krugman has thought about all of these issues. Italy has severe problems today, but to argue that all would be right if they could just print money ignores some important historical lessons. Germany and Sweden were star economies of 2010-11 but that was largely thanks to ultra-orthodox public finances and sound money. These facts simply don’t fit a simple progressive narrative.

What is Krugman’s alternate explanation for the ongoing European troubles? Krugman sees European problems as reflecting only the constraints imposed by monetary policy. In turn, he seeks to indict American free-market economists as being a substantial force in favor of the Euro.

From his column, he argues:

First things first: The attempt to create a common European currency was one of those ideas that cut across the usual ideological lines. It was cheered on by American right-wingers, who saw it as the next best thing to a revived gold standard, and by Britain’s left, which saw it as a big step toward a social-democratic Europe. But it was opposed by British conservatives, who also saw it as a step toward a social-democratic Europe. And it was questioned by American liberals, who worried — rightly, I’d say (but then I would, wouldn’t I?) — about what would happen if countries couldn’t use monetary and fiscal policy to fight recessions.

The lack of quotations or links is typical of Krugman’s work. Who are these “right-wingers” that so ardently supported the Euro project? Were these views typical of conservative economists at the time? Certainly, Krugman faces space constraints in his column. But even on his spacious blog, Krugman choose not to identify a single figure, referring only to “the Wall Street Crowd.”

For some perspective on this issue, it’s worth revisiting an article by Lars Jonung and Eoin Drea published in January 2010. The authors outlined the views of American economists at the time of the Euro’s adoption. While the article presents an interesting retrospective on the Euro’s adoption, it fails to support Krugman’s ideological narrative.

First, Jonung and Drea argue that the major divide among American economists was not across liberal or conservative lines, but rather between the Federal Reserve banks and academic institutions, with Federal Reserve economists tending to have a more positive view on the Euro’s adoption – focusing on the benefits of a single market and currency in fostering economic growth. Other economists were positive of the Euro overall, while being more skeptical about the timing of reforms – pointing to the fact that several countries seemed not to be following Maastricht norms that were designed to govern countries in the Euro (indeed, several countries have found compliance with these norms difficult over the length of the Euro’s adoption).

Academic economists, in general, were more skeptical of the Eurozone project: pointing to the difficulties of monetary integration. A key concept in this debate was the notion of an optimal currency zone – the conditions of trade openness and mobility that determine which regions ought to share a common currency. Many arguments over the desirability of the Euro simply stemmed from good-faith disagreements over whether or not European countries constituted an optimal currency area.

One famous debate in 2001 over the Euro came from conservative economists Milton Friedman and Robert Mundell (though Krugman might label these Nobel Laureate winners “right wingers”). Mundell was a key originator of the idea behind optimal currency zones, and also supported the Euro, while Friedman was an adamant opponent. Their debate serves as a fascinating discussion of currency issues that remains relevant today.

Mundell and Friedman both regarded the gold standard as a failed experiment. While Mundell did support fixed exchange rates and the Euro, he did so instead on the grounds of wanting to advance markets that were conducive for economic exchange. By contrast, Friedman argued that the political difficulties of maintaining a common Euro would prove insuperable. In particular, his concerns seem highly prescient, as he argued:

Friedman [The Euro’s] real Achilles heel will prove to be political; that a system under which the political and currency boundaries do not match is bound to pro unstable. In any event, I do not believe the Euro will be imitated until it has a chance to demonstrate its viability

Another conservative critique of the Eurozone project came from the conservative Martin Feldstein, who argued:

Britain, France and the other countries of Europe will want to form a continental government in which Germany has the largest population and the strongest economy as a way of limiting Germany’s future power or the military exercise of that power.

Again, concerns about German dominance are (still) a key aspect of ongoing European negotiations.

The fact that conservative economists could disagree so strongly on currency zones highlights the fact that this debate is not all about ideology. Indeed, a less ideologically driven article may have simply highlighted the numerous and specific warnings about the creation of the Eurozone (and calls for how its collapse was likely inevitable) from “right-wing” – to use his term again – economists like Milton Friedman and Martin Feldstein.

Liberal economists also held a diversity of views. For instance, Barry Eichengreen, a prominent liberal economist focused on international issues, wrote extensively on the Euro. His research emphasized the low level of mobility within Europe – a reason it might be a poor currency zone – and also the difficulty of handling fiscal federalism in a new Europe. However, he also broadly saw a common European monetary zone as a building block to a deeper political union.

This brief survey clearly omits an enormous diversity of views, just among American economists, about the wisdom of the Euro. However, it seems clear that Krugman’s intellectual revisionism just doesn’t match the published literature on the Euro. If anything, we think the evidence shows that conservative economists were more against the Euro – perhaps because they were more skeptical of efforts to integrate European political structures in the absence of a deeper consensus. Again, liberal economists, if anything, seem to have been supportive of the goals of deeper political consensus. But the debate was equally dominated by intellectual concerns over the degree to which European countries could conceivably be integrated, or how the new political process would look – certainly prescient concerns.

The ongoing European problems certainly present an interesting set of concerns for policymakers. Therefore, it is disappointing to see Krugman adopt simple narratives that deny any relationship between too much government debt and too much government spending; and claims that seem to pin the “blame” for the Euro more on silent “right-wing” economists. The reality in Europe is much more interesting and complex.


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