The European economic and monetary union is doubly flawed. First, it forces diverse countries to live with a single interest rate and exchange rate that cannot be appropriate for all members. Second, combining a single currency with independent national budget policies encourages fiscal profligacy. The Greek situation is a manifestation of these flaws. If European political leaders nevertheless want to preserve the current system, allowing a temporary exchange rate reset for Greece may be the best option.
He says that Greece needs to go off the euro, temporarily, for the same reason that I said it needs to. Greece needs the expansionary effects of devaluation, so that the economy expands while it cuts its budget deficit.
Neither Feldstein nor I address the concern of the effect of a devaluation on banks, particularly in Greece but perhaps also elsewhere in Europe. Tyler Cowen wrote
Talk of Euro abandonment would trigger an immediate run on Greek banks, sending the country into an even deeper hole. Who wants a Euro deposit to be converted into a drachma deposit?
READER COMMENTS
Joey Donuts
Feb 17 2010 at 9:29am
Maybe we should try something like this with California and other profligate states.
Joe Torben
Feb 17 2010 at 10:28am
I was going to write pretty much exactly what Mr Donuts wrote (except I intended to be more chattering and less to the point…)
Seriously, why is parts of western Europe too large to be one currency area, but the US isn’t? I have seen the question raised dozens of times, but I have never seen it answered.
Arnold Kling
Feb 17 2010 at 10:36am
Joe,
The main reason that Europe is not an optimal currency area is that labor is not mobile. You can move from Michigan to Oklahoma without having to learn a new language. Not so with moving from Greece to Germany.
Because labor is not mobile, it becomes relatively easy for relative wages to get out of alignment. One way to adjust relative wages is for the currency values to adjust. If you put people in the same currency area, you eliminate that adjustment mechanism.
Right now, Greek wages need to fall relative to German wages. Without a currency adjustment mechanism, that means forcing Greek workers to accept pay cuts, which in turn means strikes and other disruptions.
Joey Donuts
Feb 17 2010 at 11:59am
I agree that labor in Europe does not have the same mobility as labor in the US. However, European labor does have SOME perhaps a great deal of mobility, just less than US labor. As real wages fall in Greece the Greek labor would become more mobile. All you have to do is look at the influx of Turks, Lebanese, Egyptians and others into Europe looking for higher wages in spite of significant language barriers.
Furthermore why do you think that forced reduced wages because of currency devaluations would cause fewer riots than other forced wage reductions. Of course all Greeks could be fools, but I don’t think so.
mark
Feb 17 2010 at 12:33pm
Infectious Greed has good posts today on Greece and related issues. I commend “Our Debt: Your Problem”; “The Future of Public Debt” (scary);and “Europe’s Slow Painful Death” (post-scary).
http://paul.kedrosky.com/
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