A Goolsbee is Haunting Europe

In a WSJ op-ed, further elaborated in an interview with Ezra Klein, Austan Goolsbee lays out some of the fundamental problems of the Euro, which go deeper than the immediate financial crisis.  In particular, the common currency closes off the avenue of exchange rate adjustment. That is, without the Euro, the DM would be rising and the Lira and Peseta falling, improving Italian and Spanish current account balances.  He concludes:

[E]ven if Europe addresses the banking-capitalization crisis of the moment, and even if it struggles its way through the near-term fiscal crises of Greece and Italy, then what? With little prospect for growth in its South, Europe remains on the romantic road to nowhere—a road that merely runs in a circle. Without growth there will always be another fiscal crisis ahead for yet another country unable to balance its budget but prevented from devaluing and exporting its way forward.

On this path, Europeans will forever need to fight off financial and fiscal panics while trying to build their castle on a hill.

What really matters is the real exchange rate - i.e., the price of one country's goods in terms of another's.  The real exchange rate between two countries is the nominal exchange rate times the ratio of the countries' price levels.  Even if both countries have the same currency, the real exchange rate changes if they have different inflation rates.  This means that Greece, Italy and Spain can have a real depreciation vis a vis Germany by having lower inflation, which would, over time, make their goods relatively cheaper.  Of course, to get very far with this, if German inflation is low, then the peripheral countries' price levels actually need to fall.  This is sometimes called "internal devaluation", and because it entails deflation, is quite painful.  This what Goolsbee is talking about when he says: "In the short run, that would mean directly and significantly grinding down wages to make them competitive—a grisly option, prone to causing mass unrest."

I think this would be significantly less painful if it didn't involve price levels actually falling and, in principle, it doesn't have to.  For simplicity, say the Eurozone consists of a "core" and "periphery" of equal size.  If Eurozone inflation is 4%, it could be 7% in the core and 1% in the periphery, which means the periphery experiences real depreciation at a 6% rate.  However, the ECB is quite firm about sticking to its mandate - which reflects German preferences - for inflation at or below 2%.

In a way, this is analogous to the Akerlof-Dickens-Perry case that slightly positive inflation facilitates real wage adjustment because it allows some real wages to fall without forcing very difficult nominal wage cuts.