In Troubled Europe, Agonizing Options

Daniel Davies, an analyst and member of the “Crooked Timber” blogging group, had a very good post published recently — written in the form of a role-playing adventure game — about Greece (at crookedtimber.org); the point was that there aren’t any good answers, and certainly not for the government of Greece, given the situation that the creation of the euro and the initial debt bubble within the euro area have created.

It really is an agonizing position for all the troubled peripheral economies. At root, their problems are primarily caused by balance-of-payment issues rather than sovereign debt issues; they had huge capital inflows between 1999 and 2007, which led to inflation, and now they need somehow to regain competitiveness.

But overlaid on this is a sovereign-debt crisis, which has forced them to seek aid — and the lenders are
demanding harsh austerity in return, which is further depressing economies already suffering from severe overvaluation.

It’s not too hard to see what Europe as a whole — which, in practice, means the European Central Bank and the Germans — should be doing: less in terms of demands for austerity, much more general reflation (the whole situation would look much better with euro zone inflation of 3 or 4 percent). And you can make the case that austerity, at least at this level of harshness, is actually counterproductive even in fiscal terms: it depresses growth, so that the debt position becomes worse even if the current budget deficit is reduced.

It’s much harder, however, to say what the leaders of such peripheral economies should do. Unilateral default won’t solve the competitiveness problem, and at least for now would actually worsen the fiscal squeeze, since they’re all still running primary deficits (that may change in a year or so).

Euro exit would allow a quick devaluation, solving the competitiveness problem — but it would be hugely disruptive and would generate vast ill-will, so it’s hard to see any government taking that step unless there really were no alternatives (which may soon be true for Greece, but not the others).

So there’s a kind of trap. If you imagine yourself as the prime minister of such a country, what can you do? For the most part, I’m afraid, you plead with the troika to make the austerity demands less severe, you do what you can to accelerate improving competitiveness (which isn’t much), and you wait for things either to get gradually better via “internal devaluation” or to get worse and provide the economic and political environment in which euro exit becomes a real possibility. It’s a hell of a way to make economic policy, but I don’t see any magic bullets.

Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007).

Copyright 2012 The New York Times.