Will inflation save the European economy?

In his latest column, Paul Krugman believes that he has the answer to saving the European economy from disaster. The solution? In a word, inflation. Yes, if the European Central Bank will show the "courage" to print more money, everything will be fine.

I admit that at one level, Krugman is correct when he writes:

So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression.

More specifically, the creation of the euro fostered a false sense of security among private investors, unleashing huge, unsustainable flows of capital into nations all around Europe’s periphery. As a consequence of these inflows, costs and prices rose, manufacturing became uncompetitive, and nations that had roughly balanced trade in 1999 began running large trade deficits instead. Then the music stopped.

Note that Krugman does not think that countries like Greece have been irresponsible, or at least he indicates such in this column. Instead, he seems to believe that another round of inflation would pretty much solve everything.

Krugman is correct when he says that the single currency of the euro did impose some requirements, although like a typical Keynesian, he believes that any fiscal discipline really is a bad thing, given that all wealth creation begins with government spending. When Europe went to the euro, it meant that when governments like that of Greece borrowed from European banks, they would have to generate the revenues via taxation to pay back the loans.

Obviously, that would restrict the Greek government's behavior, given that it could not print euros, and borrowing would have to be done at a sustainable rate. Unfortunately, given the fact that Greece, like many other small European countries, has a bloated public sector that is controlled by militant labor unions, it was inevitable that the Greeks sooner or later would borrow well beyond any threshold to pay back the loans, given that fiscal discipline does not exist with the Greek government.

Unfortunately, Krugman believes that fiscal discipline is bad, bad, bad, and that inflation is a much better "solution" to any problem that the Law of Opportunity Cost might pose when governments spend themselves into a corner. (Don't forget that in his book, The Return of Depression Economics, Krugman declares that literally printing money creates a "free lunch" -- his words.) He writes:

If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.

That might be true, although Krugman forgets that if Greece still were on the drachma, then the banks might have been more reluctant to lend to that government -- although the prospect of being backstopped by the European Central Bank might have been enough to encourage the banks to lend even when they figured being paid back in euros was a stretch. Even so, if the loans had been in euros and Greece were on the drachma, then Greece still would have had the same issues, given that the banks would not have been willing to accept drachmas in repayment.

By being on the euro and with the liberal lending policies by banks, the Greeks were getting a free ride, and they knew it and believed that they were entitled to it. This is something Krugman never addresses because (1) the inevitable outcome would fall into the Opportunity Cost category, and all good Keynesians know that printing money trumps laws of economics, and (2) government spending CREATES wealth and the more government spends, the better off we are.

Likewise, when Krugman has called for the U.S. Government to borrow money and then give it to state governments, he claims that such actions would "stimulate" the economy and foster economic recovery. When California's government employee unions take an ever-growing bite of the Golden State's revenues and overall economy, Krugman refuses to see this situation as the unions plundering everyone else. Instead, he seems to believe that the unions are the responsible actors, and anyone who thinks otherwise is evil.

Keynesian theory literally turns economics on its head. Spending and printing money create wealth; wealth creation through saving, capital formation, and judicious choices by consumers and investors creates depressions and should be stopped by government, which should use force, if necessary, to keep people from acting responsibly.