Bring on the coolies!

The Greek crisis poses an incredible challenge to Europe and could pose a threat to the US recovery. I think Paul Krugman has it right: even if Greece defaults, the magnitude of the fiscal adjustment it will have to endure is greater than is consistent with its membership in the euro system. The problem is that reducing its deficit will be extraordinarily contractionary. Its participation in the euro system does not allow it to soften the blow with a monetary expansion or devaluation of the currency. Europe does not have the type of interstate fiscal transfers that would cushion the economy in the US.

Greg Mankiw calls Krugman's argument "thoughtful and thought-provoking." Mankiw then offers some of his own thoughts, which I can only describe as "head-scratching and mind-numbing." Referring to the fiscal transfer issue, Mankiw writes

Is that right? I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine...

One might argue that the 19th century had a different set of labor institutions than we have today, and these facilitated the adjustment of wages. That argument, suggested by the research of Chris Hanes, may have some merit. If that is the case, then maybe that is the path forward for Greece and the rest of Europe. As Paul suggests, increasing wage flexibility won't be painless. Yet it might be easier than giving up on the Euro experiment.

The snarky response is to remind N. Greg that 19th century America's labor market institutions included slavery, coolie and child labor, and a host of other abominations. Setting the snark aside though, the problem with Mankiw's argument is that the political system in the US, not to mention Europe, would not, cannot tolerate the type of volatility, hardship and dislocation that the 19th century business cycle entailed. Current US fiscal institutions developed, by design or by chance, at precisely the moment at which US political institutions ceased to be tolerant of the unfettered 19th century business cycle and government took on a greater responsibility to ensure economic stability.

Let Greece free up its labor markets to 21st century northern European standards, by all means, but imagining that Greece could increase flexibility to anything approaching that of 19th century Europe is quite batty.