Translation by Peter Bartl

SYNOPSIS: German interview with Krugman at the verge of the launch of the Euro. Krugman issues realistic plea for structual adjustments that would help reduce overly high unemployment.

Die Zeit: Germany, like most countries of the European Union, is suffering from high unemployment. Could an increase in demand help us, as John Maynard Keynes recommended?

Krugman: I'm convinced of that. Germany does have, like many European countries, high structural unemployment, which must lie between seven and nine percent in the euro area. But Europe also suffers from weak demand. Whether you consider the inflation rate – at the moment we must speak of deflation instead – or the level of unemployment, everything suggests that the EU needs a strong stimulation in demand.

The IMF says that four fifths of the unemployment have structural causes, which means it cannot be fought with stronger demand. Do you think that's exaggerated?

It may well be that the structural unemployment is indeed as high as that. But one can only be sure about that after the level is reduced by the margin that is obviously due to the economic activity.

Now German experts say that a lack of demand is not the problem, rather conditions on the supply side are not right. Therefore Keynesian policies could not help us.

I never understood this kind of argument. If we know that at least 20 percent of unemployment is due to the economic activity, and can therefore be solved without the danger of higher inflation, then we should start there. As an economist I always ask myself which impediment to more jobs I can remove right now. I can take care of the rest later.

You have spoken of deflation. Aren't you exaggerating somewhat?

No, I am seriously worried. In the last three months consumer prices have actually fallen in German – that's deflation. Even if the inflation rate were zero instead of negative, it would be already in a dangerous zone.

Let's assume you're right – what's the way out? Higher government spending or tax cuts?

That can only be, always, the second line of defense. At first monetary policy must help. That is cleaner, because then no budget deficit is created. Government spending programs and tax cuts, in contrast, increase the debt. Besides, they cause argument between interest groups regarding who becomes the money. That is why my suggestions involve monetary policy: the European Central Bank should get expansionary.

But the central banks of the euro countries have just cut interest rates.

This decrease of 0.3 percentage points was nothing more than a welcome for Wim Duisenberg…

…the President of the European Central Bank will from January on will be responsible for monetary policy. Do you consider that decrease to be cosmetic?

Anyway it is not enough to remove the danger of weak growth and deflation. The ECB should lower interest rates to two percent.

You mean a decrease of one percentage point, and at once?

Yes, immediately. There's no reason not to do it. The ECB should take the chance before it's too late, for in an extreme case Europe could get stuck in a deep recession, like Japan. And then even lower interest rates will not help.

German Finance Minister Oskar Lafontaine has been calling for lower interest rates for weeks. But the presidents of the central banks have mostly told him that interest rates in Europe are already too low and are certainly not preventing growth.

During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn't you lower interest rates? In Europe, growth stagnates, prices fall – everything suggests that part of Euroland's economy is not active. Why shouldn't the ECB try to stop the drift into deflation?

The central bankers will answer that they have already lowered interest rated enough, and a further cut would have no result.

That's exactly where I disagree. Even if the positive effects were uncertain – it is odd that nobody can say why Euroland may not cut interest rates. If you ask, they answer that to cut rates is unreasonable. Why is it unreasonable? Because it is!

Or because that would only promote inflation instead of growth?

There is no danger of that! That reminds me a little of the depression of the thirties. Then, many people also said: we cannot be too expansionary, that will only cause inflation. The danger for Europe, as for Japan, is deflation, not inflation. The longer you wait, the higher the risk.

The German government believes that stable exchange rates between the euro, the dollar and the yen would promote growth. It has called for exchange-rate zones. What do you think of that?

I hope I'm not being too hard on your government, but I've never been a friend of exchange rate zones, for many reasons. First, we have no idea what should be the correct exchange rate between the dollar and the euro, or between dollar and yen. It is almost certain that a wrong rate would be aimed at and we'd have a lot of trouble. Second, exchange rate zones would be an ideal pretext for the central bankers to keep interest rates high, because they could always claim that they must defend the exchange rate.

Do you favor floating rates?

Exchange rates should be either totally fixed or totally flexible; compromises do not work in this field. Precisely at times of fundamental economic changes, like today, we should let the exchange rates float freely between the great trade blocks: Japan, Europe and the US.

In Europe we talk much more often about the mixture of supply- and demand policy, the "Third Way". Is that a sensible proposal?

Surely you know the joke about Bill Clinton and Tony Blair. Both were asked the difference between their strict social policies and that of their predecessors, Reagan and Thatcher. They answered, compassion. We have compassion for the victims of our policies.

You don't seem to be a enthusiastic follower of the "Third Way".

I have never understood what that's supposed to mean. If you mean job creation, there are two reasons why many jobs are created in the US. The social safety net is very limited, people are forced into the job market. At the same time monetary policy is expansionary. In continental Europe it's the opposite, the safety net is very generous and monetary policy is rigid. In both respects Europe should move a little towards the US, without your social policies having to become as hard as ours. But you cannot avoid structural reforms.

What do you mean exactly?

Something must happen in the job market. Wages aren't flexible enough, and unemployment insurance does not offer enough incentives to actually take a job or even to change jobs.

Don't such reforms cause precisely the poverty problems that you criticize in the US?

We must be clear about one thing: the correlation between supply and demand is also valid for the labor market. For instance, if the government can make the costs of hiring new employees sink, companies will hire more people and unemployment will fall. The same is true when the unemployed are forced to accept a job. That doesn't mean that we must simply accept increasing inequality. But the latter should be fought with measures that do not interfere in the labor market, such as income supplements.