Krugman on the European Disease

This Sunday's New York Times has Paul Krugman's examination of the problems in the European Union.  It's not all bad - especially the part where he cites Milton Friedman in favor of national, as opposed to multinational, currencies.  Krugman explains why the European Union is not actually a good candidate for a common currency.

However, his empirical examples: Iceland vs. Brooklyn and Nevada vs. Ireland are problematic.

Krugman claims that Iceland, which has its own currency, has weathered the storm better than the euro bloc because of its independent money.  (He asks rhetorically why Brooklyn, which has eight times more people, doesn't also have its own currency.  The anwer is that it is too closely integrated with its neighbors, so the friction costs of changing money between Brooklyn and Manhattan, for example, would outweigh the benefits.)

However, I find it hard to stomach that Iceland's independent currency helped it survive the recent turmoil.  Iceland's banks are where the crisis started: British and other depositors were attracted to deposit their savings in Icelandic banks at high interest rates.  With perfect hindsight, we now see that the interest rates did not compensate for the risk!

With respect to Nevada and Ireland, Krugman notes that they have about the same population and the same economic crisis, centered especially in the housing market.  However he notes that Nevada has dodged the crisis that Ireland has suffered, which he attributes to the fact that Nevada enjoys entitlements paid for out of the U.S. Treasury.  If Nevada had its own Medicare and Social Security, it would now be forced to cut them back, like Ireland will have to do.

Krugman believes that a currency union and the welfare state have to be at the same level of government.  Because he does not anticipate that Europeans will ever "supersize" the welfare state- i.e. make the European Union, rather than national governments, responsible for entitlements, he advocates going back to national currencies.

In the narrowest of senses, he is likely correct.  However, in the long term, I suspect that the United States' greater ability to "kick the can down the road" and run up ever increasing unfunded liabilities by turning our central bank into a hedge fund means that Ireland will have sorted out its problems well before Nevada - and the other states - are forced to pay the piper.