Paul Krugman has an interesting column in Sunday’s New York Times; it is also appears in the Business section of today’s Irish Times. There is much that I agree with in the article regarding the boarder European crisis resolution response. But I think his comments on Ireland’s adjustment policies are off the mark. Paul complains about Ireland being used as a misleading data point in the international debate. I think Paul is himself guilty on this score.
Here’s what he says about Ireland:
What’s wrong with the prescription of spending cuts as the remedy for Europe’s ills?
One answer is that the confidence fairy doesn’t exist – that is, claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the past two years. So spending cuts in a depressed economy just make the depression deeper. Moreover, there seems to be little if any gain in return for the pain.
Consider the case of Ireland, which has been a good soldier in this crisis, imposing ever-harsher austerity in an attempt to win back the favour of the bond markets. According to the prevailing orthodoxy, this should work. In fact, the will to believe is so strong that members of Europe’s policy elite keep proclaiming that Irish austerity has indeed worked; that the Irish economy has begun to recover.
But it hasn’t. And although you’d never know it from much of the press coverage, Irish borrowing costs remain much higher than those of Spain or Italy, let alone Germany.
A number of responses:
1. As far as I can see, those involved in the design of Ireland’s adjustment programme do not believe in the “confidence fairy”. It has been explicitly recognised that fiscal adjustment slows the economy. The programme has been designed in order to balance the need put Ireland on a fiscal path consistent with debt sustainability and regaining the country’s creditworthiness, while securing needed official lender support, and minimising the adverse effects on the real economy through a official-lender supported phased adjustment approach.
2. Ireland’s growth performance has been disappointing. But the causes of the poor performance go well beyond the effects of fiscal austerity. The weight of impaired balance sheets in a post-bubble and a weak international environment are also major drags on growth. Of course, Paul is far too good an economist not to realise this.
3. It would be true that Ireland’s adjustment effort is failing if the fiscal measures were directly self defeating in terms of improving the underlying fiscal situation. There are a number of relevant measures: Are the fiscal adjustments leading to an improvement in the underlying primary deficit? Are these adjustments improving the underlying path of the debt to GDP ratio and putting Ireland on a path to debt to GDP ratio stabilisation? And are these adjustments helping to restore Ireland’s creditworthiness?
On the underlying primary deficit, the number has come down from 9.7 percent in 2009 to 6.0 percent in 2011, with a projected further fall to 4.2 percent in 2012.
On the debt to GDP ratio, the calculation is more complex because we have to see how adjustments affect the path of the ratio. For plausible multipliers, it is certainly possible that the debt to GDP ratio rises in the year of adjustment due to a strong adverse effect on the denominator. For example, using an automatic stabiliser coefficient 0.4 – a key parameter in determining the possibility of self-defeating adjustment – simulations show the debt to GDP ratio would rise this year as a result of a (permanent) additional €1 billion of adjustment with a deficit multiplier of 1. However, this ignores the positive effect on the future debt ratio of lowering the nominal primary deficit this year, which will lower the nominal debt and thus interest payments in the future. Simulations show that the multiplier would have to be as large as 3.8 – completely implausible for a small open economy – for the debt to GDP ratio to be actually higher in 2015, all else equal.
On creditworthiness, the impressive recent work of Delong and Summers introduces the possibly adverse effect of “hysteresis” on creditworthiness. (The effect here refers to the fiscal shadow cast by lower output today due to persistent effects on output.) This is harder to get an empirical handle on due to the difficultly in observing these effects. However, notwithstanding the fact that Ireland’s bond yields are above those in the Germany or even Spain, the improvement in Ireland’s market creditworthiness has been dramatic since last summer as Ireland’s adjustment programme has gained credibility. (The evolution of Ireland’s 2-year bond is shown here; the 9-year yield here.) This has occurred despite increasing evidence of the damage done to the economy by the bubble, despite the euro zone crisis remaining in flux and despite the clamour to abandon the adjustment programme and default.
The success of Ireland’s adjustment programme is too important for it to be used as misleading fodder in a debate over appropriate fiscal policies for creditworthy countries.