Monday, May 10, 2010

Krugman on the Euro Area (ls)

Paul Krugman's recent column provides an unpleasant analysis of the current crisis.

Here are the most remarkable statements:

"So is a debt restructuring — a polite term for partial default — the answer? It wouldn’t help nearly as much as many people imagine, because interest payments only account for part of Greece’s budget deficit. Even if it completely stopped servicing its debt, the Greek government wouldn’t free up enough money to avoid savage budget cuts."
To be honest, this fact is new to me. I was rather concerned about the exposure of European banks -  respectively about the uncertainty regarding individual exposures and  counterparty risk - and the potentially adverse consequences for interbank markets.
"Logically, I see three ways Greece could stay on the euro. First, Greek workers could redeem themselves through suffering, accepting large wage cuts that make Greece competitive enough to add jobs again. Second, the European Central Bank could engage in much more expansionary policy, among other things buying lots of government debt, and accepting — indeed welcoming — the resulting inflation; this would make adjustment in Greece and other troubled euro-zone nations much easier. Or third, Berlin could become to Athens what Washington is to Sacramento — that is, fiscally stronger European governments could offer their weaker neighbors enough aid to make the crisis bearable. The trouble, of course, is that none of these alternatives seem politically plausible."

For students - and of course for us either - the current events are an interesting "case study" concerning the theory of optimal currency areas. The Greek problems clarify the lack of adjustment mechanisms in the Euro Area. Therefore the Euro sceptics - arguing that the current institutional design keeps the Euro Area far away from being optimal - seem to be finally right.

Readings for students: If you want to get into OCA-theory, I highly recommend this book by Richard Baldwin and Charles Wyplosz, especially chapter 11 und 16-18.