Euro Agonistes

Paul Krugman
NYT

Daniel Davies had a very good piece — written in the form of a role-playing adventure game — about Greece; the point was that there aren’t any good answers, certainly 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-payments 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 ECB and the Germans — should be doing: less demands for austerity, much more general reflation. (The whole situation would look much better with eurozone 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 until there really are no alternatives (which may soon be true for Greece, but not the others).

(More here.)