Wrong Question Professor Krugman!

In a recent post, Paul Krugman dismisses the idea that Dubai may be the first of many more sovereign defaults. But Krugman also ignores the real danger facing many states: a combination of big debts and fixed exchange rates.

Paul Krugman lays out three scenarios for Dubai, ruling out only the first.

First, there’s the view that this is the beginning of many sovereign defaults, and that we’re now seeing the end of the ability of governments to use deficit spending to fight the slump. ... For what it’s worth (not much), US bond prices are up right now, suggesting that the Dubai thing hasn’t raised expectations of default.

But there's a lot of room between fears of "many" sovereign defaults and fears of a default by the strongest sovereign of them all. What about Greece?

Brussels says Greece's public debt will rise from 99pc of GDP in 2008 to 135pc by 2011, without drastic cuts. Athens has been shortening debt maturities to trim costs, storing up a roll-over crisis next year. Some €18bn comes due in the second quarter of 2010 (IMF).

Modern economies have reached such debt levels before, and survived, but never in the circumstances facing Greece. "They can't devalue: they can't print money," said Mr Christensen. (Bolding added.)

It's the combination of big debts and a fixed exchange rate that is lethal. As Canada showed in the 1990s, a country with a floating exchange rate can cope with indebtedness easily: Let the currency decline, everybody inside the currency area takes a big pay cut, they consume less, export more, debts are serviced, prosperity returns. In 1993, world markets worried about a Canadian default; today Canada ranks among the least indebted of the advanced economies.

Inside the Eurozone, things are very different. For Greece in 2009, the Euro has the same effect that the gold standard had on a small export economy in the 1930s. Wages cannot be invisibly reduced across the board, they must be cut in nominal terms, firm by firm, industry by industry. Earning export income becomes harder, servicing debt becomes much more difficult. The only way out: either extreme austerity - or else quit (or be expelled from) the Euro. And if Greece - why not Spain? Why not Italy?

Those are the questions my AEI colleague Desmond Lachman keeps asking, and they are haunting.