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Monday, November 29, 2010

Paul Krugman: The Spanish Prisoner

Spain provides a lesson for those who believe that the Fed should pursue a "hard-money" policy focused on "keeping the dollar strong and fighting the imaginary risks of inflation":

The Spanish Prisoner, by Paul Krugman, Commentary, NY Times: The best thing about the Irish right now is that there are so few of them. By itself, Ireland can’t do all that much damage to Europe’s prospects. ...
But then there’s Spain. ... Like America, Spain experienced a huge property bubble, accompanied by a huge rise in private-sector debt. Like America, Spain fell into recession when that bubble burst... And like America, Spain has seen its budget deficit balloon thanks to plunging revenues and recession-related costs.
But unlike America, Spain is on the edge of a debt crisis. ... Why is Spain in so much trouble? In a word, it’s the euro. ...
Through the good years,... the Spanish government appeared to be a model of both fiscal and financial responsibility... But ... prices and wages rose more rapidly in Spain than in the rest of Europe... And when the bubble burst, Spanish industry was left with costs that made it uncompetitive with other nations.
Now what? If Spain still had its own currency, like the United States ... it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available. Instead, Spain must achieve “internal devaluation”: it must cut wages and prices until its costs are back in line with its neighbors.
And internal devaluation is an ugly affair. For one thing, it’s slow: it normally take years of high unemployment to push wages down. Beyond that, falling wages mean falling incomes, while debt stays the same. So internal devaluation worsens the private sector’s debt problems.
What all this means for Spain is very poor economic prospects over the next few years ... and ... fears about Spain’s fiscal future.
Should Spain try to break out of this trap by leaving the euro...? ... Spain would be better off now if it had never adopted the euro — but trying to leave would create a huge banking crisis... — it’s hard to see any Spanish government taking the risk of “de-euroizing.”
So Spain is in effect a prisoner of the euro, leaving it with no good options.
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. ...
The bad news about America is that a powerful political faction is trying to shackle the Federal Reserve, in effect removing the one big advantage we have over the suffering Spaniards. Republican attacks on the Fed — demands that it stop trying to promote economic recovery and focus instead on keeping the dollar strong and fighting the imaginary risks of inflation — amount to a demand that we voluntarily put ourselves in the Spanish prison.
Let’s hope that the Fed doesn’t listen. Things in America are bad, but they could be much worse. And if the hard-money faction gets its way, they will be.

    Posted by on Monday, November 29, 2010 at 12:42 AM in Economics, International Finance | Permalink  Comments (54)


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