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Fiscal Policy

Krugman and the ESRI

Paul Krugman criticises the ESRI’s Recovery Scenarios paper:

What the careless reader might miss, however, is the fact that the policy conclusions are not, in fact, derived from the analysis — they come out of thin air. The authors simply assert that more austerity now would lead to a lower risk premium and hence higher growth, based on no evidence I can see.

This criticism appears to relate to the paragraph on page 41 of the report starting with “Recent experience ..”

Two aspects of this criticism strike me as unfair.

First, the assertion that Krugman refers to appears to be the following concluding sentence:

It also raises the question as to whether a more rapid fiscal adjustment than currently planned would have a more beneficial outcome for the economy. 

This seems to be pretty far from an assertion. Rather it flags this idea as something to consider. Krugman seems to be jumping on the ESRI for what it is little more than a speculative remark.

Second, in relation to the “based on no evidence that I can see” comment, I’d note that the relevant paragraph contains the following sentence:

This means that action to reduce borrowing, which would otherwise still be deflationary, could actually increase domestic activity if it produced a sufficient reduction in the risk premium (Alesina, 2010).

Now I’m guessing that Krugman has no time for the analysis in Alesina, 2010 (and he may be correct in this assessment) but it’s still worth noting that the ESRI did cite evidence from a Harvard economist when making the supposed assertion.

What seems to be happening here is that the ESRI-bashing is just a small element in Krugman’s greater campaign of opposing austerity in the US and Germany (with which I’m sympathetic.)  However, it’s worth recalling that last year, Krugman noted about Ireland that “there isn’t much disagreement about the need for fiscal austerity. As far as responding to the recession goes, Ireland appears to be really, truly without options” and referred to an “Irish-type fiscal straitjacket.”

I’d be surprised if Krugman’s assessment of the bond market’s attitude to Ireland has changed much since then: The spread over bunds of the Irish ten-year bond was 282 basis points yesterday versus 293 the day Krugman’s Erin go Broke column was published.

So while kicking around a little research institute his readers have never heard of may seem to provide a nice example-de-jour of crazy people advocating Herbert Hoover economics, in truth it’s likely that even Paul Krugman doesn’t really believe Ireland is in a position to abandon austerity.

21 replies on “Krugman and the ESRI”

I like Krugman, but he’s becoming more columnist and less economist. He seems to be locked in a crusade for the past couple years.

“This means that action to reduce borrowing, which would otherwise still be deflationary, could actually increase domestic activity if it produced a sufficient reduction in the risk premium (Alesina, 2010).”

Thats a big “if”. Isn’t Krugman’s point that financial markets have not been rewarding austerity? Countries that have embraced austerity have seen their debt downgraded and their risk premiums rise. How big a reduction in our risk premium would have to materialise before we could see the deflationary effects of 3bn in spending cuts offset?

One other point which Krugman made which hasn’t been addressed on this blog is: “They don’t even offer any quantitative assessment of the extent to which more austerity while the economy is still depressed would reduce future debt burdens.” It seems a valid point to me.

I think your point about Krugman’s ‘greater campaign’ hits the mark, but it is unfortunate that his comments are being used (http://www.progressive-economy.ie/2010/07/leprechauns-and-confidence-fairies.html) and probably will be used more widely to stiffen resistance to the painful, but necessary, fiscal adjustment required.

I also think that Krugman (similar to many US economists) when viewing economic policy formulation and policy commentary in the established EU parliamentary democracies does so through the prism of political and economic governance in the US. Despite a decade of misgovernment and lax regulation there, the system of governance has demonstrated the ability to heal and renew the economy – though, perhaps, not doing so at the speed or to the extent he would like.

It is unlikely that he is fully aware of the extent to which a decade of even more egregious misgovernment and lax regulation has damaged the Irish economy – and of both the paucity of policy instruments and the inability of a broken system of democratic governance to repair the damage.

@George Orwell-

Neither of those points seem sound or valid. The question isn’t why countries embracing austerity have seen their debt downgraded relative to other countries, it is what would have happened had they not embraced austerity? And what other countries other than Ireland would you be referring to?

Moreover, why is a quantitative assessment necessary? Flip the question around. Is Krugman suggesting that additional fiscal reductions would not reduce future debt burdens? Seems like an absurd deman to make.

Good post Karl, I agree wholeheartedly.

@MarcusOC
It seems part and parcel of the US political sport that an academic economist can be one thing in the columns and another in the journals. At least that’s what I hope is going on here, because Krugman is too good an economist to lose to the columns!

Not a fan of Krugman.

However, he’s right to point to the lack of citation for this key claim, which (albeit including the reference you point to) is a little thin.

This is probably less a product of the ESRI overlooking research, as it is a lack of suitable studies for citing. Partly, because you are straying from the econometric into the realm of marketing. What will people buy, and how do we encourage them to buy?

Certainly, the link between overall debt, and bond yields is very questionable given international variations. Indeed, even the link between deficits and bond yields is not exactly transparent. As far as I can see, the editorial line of the Wall Street Journal is a more important factor than real improvements to deficit levels (although these are not unrelated either).

Sometimes, i think we talk about the global Bond markets as if they are a vast pool of well-informed actors, who calculate every variable to the last decimal place. Whereas in fact, we’re talking about quite a small pool of individuals who could not possibly soak in the details of every coutnry they deal with.

Further still, in many countries (Japan is the poster-boy, but Ireland being no exception), there is a decisive local component to the so-called “global” debt-market. Local actors, whose interest is bound up in the budgetary decisions of the State are significant purchasers of Government debt, which in turn goes to feed these deficits. Irish Life needs the State and the State needs Irish Life. Deficit reduction or expansion won’t change that.

Therefore, it’s not an easily measurable area of research.

However, even if we can’t measure the impact of increased borrowing on our risk premium; it is undeniable that borrowing at any time (especially in large deficits) is harmful to our credit rating, and generally harmful to our interests. It all has to be paid off sooner or later. Might as well take the pain now, and start working on reducing our new debt mountain (too bad we spent our youths paying off the last one).

Wouldn’t hurt to reform some of our more uncompetitive sectors either. That’s an easier way to improve competitiveness than bald wage deflation. The Competition Authorityu has dozens of cost-free recommendations in this regard.

Zombie hotels, ghost estates, confidence fairies; now I understand the term voodoo economics 🙂

As I understand, what ESRI say relates not just to price or Irish bonds, but to the view that, if measures are taken to reduce the deficit, then consumer and investor confidence will improve and domestic spending will increase. This is based party on Ireland’s experience in the late 1980s.

While it is too soon to be definite, the early indications support ESRI, not Krugman. At the time of the budget most left-wing economists and commentators predicted that it would tip Ireland into depression, through its effect on domestic spending. But, the opposite seems to be happening:

(1) The index of consumer confidence in Ireland has increased every month since December (from 42 in December to 68, a 30-month high, in May). It is true that ESRI partly produce Ireland’s consumer confidence index, so Krugman will no doubt say that they fixed it.

(2) New car sales are running at almost twice last year’s level.

(3) Retail sales, other than car sales, have been increasing slowly since December, up 2.5pc in April and May compared with December, which doesn’t seem much, but which, annualised, is a respectable 6pc.

(4) A survey of retailers (link below), reported in today’s Irish Examiner, states that 70pc of retailers say business is improving and a similar percentage say that they expect to hire new staff in coming months.

http://www.examiner.ie/business/kfcwojidojau/

(5) While spending on investment continued to fall in Q1, there was a large increase in imports in April. We need to wait for further information to know if this was partly caused by an increase in imports of machinery and equipment (we should know tomorrow when a detailed breakdown of the April import figures is published by the CSO) and, if so, whether or it is maintained in coming months.

All told, the early evidence supports ESRI, not Krugman.

@George Orwell

“One other point which Krugman made which hasn’t been addressed on this blog is: “They don’t even offer any quantitative assessment of the extent to which more austerity while the economy is still depressed would reduce future debt burdens.” It seems a valid point to me.”

The document does discuss quantitatively what would have happened if no fiscal austerity had of taken place.

Hi,
If we truly believe in austerity we need to look at our three greatest indulgences at the moment : AIB, BOI and Anglo. Not healthcare, education and policing.
It is absurd to talk of austerity and not consider these monumental wastes of money.

@ Eureka

You’ll find that most of the people calling for austerity (on this site at least) do consider the banks a waste of money. Unfortunately FF don’t appear likely to put them on the menu though.

“This means that action to reduce borrowing, which would otherwise still be deflationary, could actually increase domestic activity if it produced a sufficient reduction in the risk premium (Alesina, 2010). ”

Karl, I think you are right to highlight this as the key issue.

But I think you are wrong to assess it in a timeframe from one Krugman article to the next. Not even he would argue that these are decisive events in the life of the Irish economy.

Surely an assessment of austerity’s effectiveness in reducing risking premium would begin when austerity began? On September 1 2008 Irish 10yr yields were yielding 47bps more than Germany, yesterday that was a premium of 282bps. While some of this should be attributed to a safe-haven effect on German bunds, Irish yield spreads have deterirated against all other Euro Area members with the exception of Greece.

So the ESRI’s consideration of what might happen runs in the opposite direction to what has actually happened. The risk premium has risen sharply, one factor helping to throttle domestic lending. In May private sector credit fell at a 10.4% annual rate, the sharpest slowdown since the slump began.

@ MB

I think a useful analysis of the interaction between fiscal adjustment and bond market spreads needs to be a bit more, let’s say multivariate than the simple observation “government cuts, spreads go up”. The fact that a massive sovereign exposure to banking sector losses were run up during the intervening period may have also played a role in the increase in spreads.

Well, I’d say the ESRI are thanking their lucky stars that Krugman doesn’t have much interest in examining their track record on waste management or climate change.

Karl,

I’m glad you raised that, as of course the bank bailout/guarantees here were by far the largest of any industrialsied econonomy (=232%/228% of GDP, depending on who you read).

But the next highest bailout was Belgium, 90% of GDP. And Belgian yield spreads over Gemany have gone from 38bps to 68bps in the Sep 1 2008-July 21 2010 period). At the same time, Greek spreads have ballooned to double those even of Irish spreads. Yet their bank bailout is equivalent to 12% of GDP.

So there are many factors expressed in bond spreads, and they are always in flux. And I know you continue to do great work on exposing the bizarre logic of the hugely damaging bank bank bailout/NAMA here (which may yet have catastrophic consequences).

But, as yet, there is little comparative evidence to support the notion that a determining variable in anyone’s bond spread is the size of its bank support operation. No correlation. Although that may yet come to pass.

Until this year fiscal austerity was unique to Ireland and, to end 2009, its bond performance was the worst in the Euro Area. Things canged somewhat thereafter.

No support then, for ESRI’s contention that more of the same might produce a diametrically opposite outcome.

Wasn’t it Einstein who said repeating the same experiment and expecting to get a different result was madness?

And this from somebody sympathetic to his overall strategy of loose fiscal policy for big countries.

There are those who think Krugman is wrong there too. Paul Krugman is one of a view voices in the world today that has succeeded in truly influencing policy. I believe much of the fiscal stimulus madness we have suffered over the past few years is his fault.

The idea – espoused by some notables on this blog – that this somehow staved off recession is ludicrous.

Instead, we have merely transferred the credit bubble into the sovereign bond markets.

Depression is coming. For sure.

Sadly methinks Krugman has turned to the dark side, transformed from respected Economist to idealogical Journalist become, he has.

@JohntheO
“As I understand, what ESRI say relates not just to price or Irish bonds, but to the view that, if measures are taken to reduce the deficit, then consumer and investor confidence will improve and domestic spending will increase. This is based party on Ireland’s experience in the late 1980s.”
I agree with you there 😯 This would be my own experience with people in Ireland – once an end to tax rises (which most fools can see coming to pay down the debt) and an end to further cuts are in sight, people relax. It is the end of financial crisis and fiscal concern that gives people confidence, not telling people that you will end it. Others have called for the plan for the next few years to be laid on the table – tax rises, spending cuts, the whole lot. It doesn’t all have to happen in a year, but we need to know what the end point is.

In addition, it is rarely about the man on the street. It is the person providing him credit, particularly revolving credit who needs to be convinced. He is little swayed by deficit spending.

WRT the argument over bund spreads – the end point of Irish austerity is still a good way away. The government have shown some style in the methods they have found to shovel money at the banks – 4% of GDP last year, maybe 8% this year. What is astonishing is that we haven’t been punished further – we still lag Greece and Portugal by some way, I believe. Even Spain, with a lower deficit and debt:GDP has a higher spread some days.

@Ribbit
I fear you are right. China and Japan are about to go through painful adjustments. That will have global consequences.

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