Krugman on Flexible Labor Markets

In a recent blog post, Paul Krugman makes what I believe to be an insightful comment on the flexibility of labor markets, and there is no reason to disagree with him as far as the statement goes. The disagreement, of course, is about what to do regarding this situation.

He writes:

Perhaps the most startling and frustrating thing about the debate over the fate of the euro is the way almost everyone avoids confronting the core issue — the elephant in the euro. With a unified currency, adjustment to differential shocks requires adjustments in relative wages — and because the nations of the European periphery have gone from boom to bust, their adjustment must be downward. At this point, wages in Greece/Spain/Portugal/Latvia/Estonia etc. need to fall something like 20-30 percent relative to wages in Germany. Let me repeat that:

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

For many years, government employee unions in countries like Greece and Spain have been able to extract attractive pay packages and because the employees were being paid in euros, they found themselves enjoying a very high standard of living. However, this is not because they were earning such a standard, but rather because they had the political power to extract such standards from other people who were poorer -- and who had to do real productive work.

Unfortunately, Krugman, as a True-Believing Keynesian, does not see this relationship at work. Instead, he relies on the Keynesian belief -- based upon what I believe are accurate empirical observations -- that labor markets are less-flexible than markets for commodities. He notes:

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. (Emphasis his)

Thus, the Keynesian "solution" to this problem: inflation. In The General Theory, Keynes recognized the problem of labor costs being out-of-kilter and the difficulty in bringing them back into line, with the result being that labor would be priced out of the market and would result in high rates of unemployment.

I don't think anyone disagrees with that point, for it is pure classical economic theory at work. However, Keynes' "solution" was for government to give workers a wage cut through inflation, and he wrote that since he believed that workers only were concerned about their nominal (not real) wages, this "trick" would work time and again.

Indeed, since Krugman says that letting wages adjust by falling is not "workable," then he has the solution: inflation. Where Keynesians and Austrians differ, however, is that Keynesians see labor and factor markets as being somewhat homogeneous, while Austrians recognize that there are imbalances in these markets that are made worse by inflation. In the Austrian view, inflation is not a "solution" at all; it only exacerbates the problem, creating more malinvestments and leading to future crises.