I dare to do so again: take issue with a hypothesis by Paul Krugman. In his much cited article „there is a hole in the bucket“ Krugman identifies the following as the main pitfall of the euro area – and the main explanation for its crisis:
Think about countries like Britain, Japan and the United States, which have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies.
I don’t think so. The constraint that governments cannot fund budgets by printing money printing was not created by the euro. Monetary financing of budget deficits was outlawed – and frowned upon – all across Europe decades before that. The pre-euro Bank of Italy, for example, would have been every bit as reluctant to expand credit to its treasury as the ECB is now, if not more. And yet, Italy did not face a sovereign debt crisis comparable to what it is experiencing now.
The key constraint introduced by the euro is a different one: competitiveness can no longer be restored through exchange rate depreciation. Thus, a relatively pain free option is now lacking to grow out of excessive debts (and/or inflate them away). Non-euro countries like the U.K. have made ample use of this option during the crisis, countries like Italy can’t (any longer). And the remaining alternative, internal devaluation through wage and benefit cuts, is tough.
The problem with the Krugman-type view is that it the underlying diagnosis is incomplete, which can lead to inadequate policy prescriptions. Of course liquidity support is a key part of resolving any financial crisis. But this is not where the euro area went wrong, and thus liquidity support by itself won’t suffice. The euro area went wrong when unsustainable non-tradable sector booms in the periphery countries pushed up wages without raising productivity, giving rise to huge differentials in competitiveness between euro area economies.
And this process is bitterly difficult to reverse without nominal exchange rate depreciation. This has not been lost on investors – markets doubt the ability of economies to restore competitiveness through wage cuts alone, and therefore their ability to grow and repay debts.
Meaning: at its core, this crisis is about solvency, not liquidity.
[P.S.: I agree that monetary financing of budget deficits is – and must be – an option of last resort to stimulate demand when both standard monetary policy and standard fiscal policy run into their respective constraints (liquidity trap / debt sustainability). By joining forces the treasury and the central bank can overcome these constraints. But this is a different topic].
[P.P.S.: I see U.S.-blogger Matthew Yglesias has come round to the view that Italy’s problems may reflect more than just liquidity. Nice.]