Paul Krugman says it all this morning in the New York Times: “If Spain still had its own currency, like the United States—or like Britain, which shares some of the same characteristics—it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available.” (http://www.nytimes.com/2010/11/29/opinion/29krugman.html?_r=1&hp)
It’s that Trilemma thing again!
The Trilemma problem in international financial theory is that a nation can only achieve two out of the following three objectives: it can participate in the international flow of capital; it can have a fixed exchange rate; or it can conduct an economic policy that is independent of every other nation.
Spain, and other nations in the Euro-zone, is constrained by the first two of these objectives. Being a part of the Euro-currency-system, Spain has, in effect, a fixed exchange rate with all other nations in the Euro-zone. Spain also benefits from participating in the international flow of capital.
Given that these two conditions exist within the Euro-zone, Spain, and all other nations within the Euro-zone, cannot conduct its economic policy independently of every other nation within this currency area.
If Spain could conduct its economic policy independently of every other nation within the Euro-zone it could inflate its debt and currency all it wanted to and just suffer the injustice of seeing the value of its currency decline in the international financial markets. But, this would be “good” according to Krugman because the falling value of its currency would make its industry competitive again.
The problem in Europe, according to this fundamentalist Keynesian preaching, is Germany. Germany is the most disciplined country within the Euro-zone and hence is causing all sorts of problems for Greece, Ireland, Portugal, Spain, and possibly Italy and France. And, when times get tough, discipline wins.
This situation highlights the difficulty in attempting to build a currency area. A currency area has a single currency. So, by definition, a “fixed” exchange rate exists within the area. Unrestricted capital flows are very desirable within a currency area because everyone benefits when capital can flow to its most productive uses.
That leaves one prong of the Trilemma hanging…independent economic programs.
This has always been the “hidden bump” along the road to the formation of a currency area. Governments within the currency area need to conduct economic policies that are consistent with one another. But, governments don’t like to give up this independence.
And, if you have a nation like the Germans who believe in self-control and fiscal discipline, it becomes hard for nations who chaff at self-control and believe in credit inflation to continue upon their path forever.
Keynes realized this problem in attempting to construct his economic model in the 1920s and create the post-World War II international monetary system. Keynes knew that his proposals for debt inflation depended upon nations having the ability to conduct their economic policies independently of one another. And, he was, during this time period, very adamant about having a system of fixed exchange rates. Thus, Keynes advocated controls on the international flow of capital.
Unfortunately for Keynes’ view of the post-World War II environment, international capital flows increased, particularly in the 1960s and have accelerated ever since.
What then has to give? Fixed exchange rates or the ability of a nation to conduct its economic policy independently of other nations?
The United States, in August 1971, chose to do away with fixed exchange rates. The Euro-zone came into existence in 1993 and on January 1, 1999 opted for a one-currency system by introducing the euro to the world. The Euro-zone created a single central bank for the area, the European Central Bank which began business in 1998, but allowed national governments to still conduct their budgetary policies independently of one another.
Thus, countries in the Euro-zone could maintain self-control and discipline, if they so desired, or, they could creates mounds of debt and live way beyond their means, if that was what they wished to do. Governments did not want this choice taken away from them.
Times went well for the Euro-zone and most seemed happy with the existing arrangements. Then, the bond markets got antsy. And, we had the first “debt crisis” in the Euro-zone earlier this year. Band-Aids were felt to be appropriate.
Now, we are in the second “debt crisis” and the bill is coming due. Wouldn’t it be nice, as Krugman suggests, to keep on inflating and just let the value of the currency declining? Remember in the economic model Krugman uses there is no debt and no penalty for piling up more and more debt. No harm, no foul!
Therefore, Krugman believes, Spain should be as fortunate as the United States: “The good news about America is that we aren’t in that kind of trap: we still have our own currency, with all the flexibility that implies.”
America can create debt and inflate its currency all it wants to and no one else can do anything about it!
Yet, there is a conspiracy afoot. Now, Krugman has joined Oliver Stone! The “bad guys” are trying to stifle government spending and constrain the Federal Reserve System. These “bad guys” are trying to “voluntarily put (America) in the Spanish prison.”
Does Krugman advocate the demise of the euro? Krugman doesn’t really see this happening because of the disruption it would create. Therefore, Spain must remain in a prison of its own creation.
Germany has contemplated this move. But, Germany really doesn’t want the Euro-zone to fall apart. (See “Crises Shake German Trust in Euro-Zone”: http://www.nytimes.com/2010/11/27/world/europe/27germany.html?scp=10&sq=michael%20slackman&st=cse.)
Maybe the continuing efforts to provide rescues to member nations may lead to a more unified Euro-zone that realizes and accepts greater coordination of national economic policies. The road to such a solution, however, has many, many bumps and potholes along the way. Countries that have established overly-generous social policies may not be able to reconcile their demands with that of the more controlled nations, like Germany, that support greater fiscal and monetary discipline.
The conclusion to this story is far from over.