Paul Krugman: No One's Labor Market is Flexible Enough to Make the Euro Work

The problem with the eurozone as currently constituted is that there are wide differences in both the business cycles and the relative productivity of various members.  Normally those differentials are handled by currency fluctuation and monetary policy.  The US finesses the problem of imperfect currency union with mobile labor markets and automatic fiscal transfers.  Absent these, all the work of adjustment has to be done by flexible wages.

Unfortunately, wages just aren't that flexible--at least not downward.  Wages are what's known as a "sticky" price, which is to say that they get stuck at various points.  In the case of wages, that means that they're very unlikely to adjust downward.  In part that's psychological adjustment, and in part that represents the long-term nature of peoples' obligations; if you have a mortgage, a couple of car payments, and some student loans, it's hard to suddenly take a 10% pay cut because business is off.  That's why recessions tend to be characterized by sharp spikes in unemployment; unable to spread the pain, employers have to fire workers.

Paul Krugman offers a taste of just how big an adjustment will be required:

WAGES IN THE PERIPHERY NEED TO FALL 20-30 PERCENT RELATIVE TO GERMANY.

How hard will it be to achieve this? Look at Latvia, which has pursued incredibly draconian austerity. Unemployment has risen from 6 percent before the crisis to 22.3 percent now -- and wages are, indeed, falling. But even in Latvia labor costs have fallen only 5.4 percent from their peak; so it will take years of suffering to restore competitiveness.

The official answer is that this just shows the need for more flexible labor markets. But this was a subject we all batted back and forth in the initial debate about the euro, circa 1990: nobody has labor markets that flexible. If the euro isn't workable without highly flexible nominal wages, well, it isn't workable.

I don't know whether Krugman is right that wages in the periphery have to take a 20% nosedive in order to mediate the productivity differentials.  But I do know that he's right that nobody's labor market is that flexible.  In theory, it could happen, over a period of long years.  But it is nearly impossible for me to imagine any country sticking it out that long when devaluation is so tantalizingly possible.

US states don't talk about this sort of thing because our labor markets are more flexible, because federal policy considerably eases the frictions, and because most of our states never had the capacity or identity to act as an independent government.  (Given labor mobility, people would refuse to secede simply because they have too much family and other ties in the rest of the country).  None of these things are true in any of the eurozone nations; they're nations, with a strong national identity.

All of which is to say that, like Paul Krugman, I find it hard to imagine all this ending well.  But the universe has surprised me before.