Monday, December 12, 2011

Return of the Master. Keynes won.

"Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary."

Paul Krugman points to this piece by economic historian Kevin O’Rourke:

"One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and now-casting.com is predicting declines in eurozone GDP for late 2011 and early 2012.

A second, related lesson is that it is difficult to cut nominal wages, and that they are certainly not flexible enough to eliminate unemployment. That is true even in a country as flexible, small, and open as Ireland, where unemployment increased last month to 14.5%, emigration notwithstanding, and where tax revenues in November ran 1.6% below target as a result. If the nineteenth-century “internal devaluation” strategy to promote growth by cutting domestic wages and prices is proving so difficult in Ireland, how does the EU expect it to work across the entire eurozone periphery?

The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members’ loss of ability to devalue their exchange rates is a major cost. Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.
"

End of argument?

And here's an excellent long piece from the NewYorker on the return of the master.






Related Posts

. Krugman on the breakdown of the consensus

. What went wrong: David Gruen

. Quiggin, Zombie Economics


8 comments:

Anonymous said...

This framing is misleading though it will play well with non economists. Reduced govt spending does lead to contraction (isn't this logical/expected ceteris paribus?). The issue is that in the long to medium term, the economy regains itself on a sustainable footing (i.e. gdp is based on fundamental demand as opposed to unaffordable\unsustainable debt). Yes a credit card addict will suffer a decline when you lower his credit limit. What is called austerity in this case is simply a period of living within means for a certain period. Not sure how it proves that we can borrow ourselves out of debt.

Peter Martin said...

Hi.

You say

Reduced govt spending does lead to contraction (isn't this logical/expected ceteris paribus?)

I am glad that it now seems logical.

But for years we were told that cutting govt spending would boost private investment. Remember "crowding out"?

Thank heavens we don't hear much about it now.


I agree with you that finances need to be on a sustainable footing.

But we now know that getting them there, swiftly, can do great damage.


I don't understand your reference to whether we can "borrow ourselves out of debt".

It is not a claim I have made. As far as I know it is not a clam made in the articles I linked to.

Anonymous said...

Hi Peter,


Borrow ourselves out of debt – refers to the Krugman’s prescription (and the reason for this debate in the first place hence relevant) for getting the ailing US/European economies out of recession. His view simplistically expressed is that AD is down and you boost AD (and increase employment in the process) by expanding Govt spending which in the US/European context can currently only be financed by debt (I hope this is not up for dispute). The opposite view is that the ‘animal spirits’ (Keynes!) got out of hand and AD was artificially boosted by debt (i.e. we were consuming what we could not afford) and the overhang of debt (governments, consumers etc) is limiting consumption. The argument is whether we run an expansionary fiscal policy (taking on even more debt and causing bigger problems down the road) or take painful decisions now (lower debt i.e. contractionary fiscal policy as current US/European fiscal policy is based on unsustainable debt) and resolve the issue instead of just kicking it down the road further.

It goes without saying that one side identifies a contractionary policy as reversing certain goals (less government services) while the other side identifies an expansionary policy as an expropriation from the rightful and productive (inflation etc). The debate seems less about economic merits than ideology, Krugman being one of the chief offenders.

Also I would think crowding out following the same logic as my last comment (demand for borrowing vs. limited debt available for lending would increase interest rates, ceteris paribus) seems legitimate enough? As usual the devil lies in the details.

The Lorax said...

Austerity cannot fix Europe, only a breakup can fix Europe.

I am no Euro-skeptic, but it should be clear to everyone now that the beautiful idea of a single currency didn't work, and can never work, and its time to deal with reality. As O'Rourke says:

Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation.

The only long-term solution for the PIIGS is debt-forgiveness and a return to their original currencies. The alternatives are money-printing or a decade of grinding austerity, which will solve nothing. I'm looking forward to a very affordable Grand Tour of southern Europe in 2012!

P.S. While we're at it, it would be nice if WA exited the Australian dollar and the rest of the country could have a more appropriate exchange rate.

Anonymous said...

Peter you said:

But for years we were told that cutting govt spending would boost private investment. Remember "crowding out"?

It's my belief that cutting the taxes that eventually pay for all the government spending that boosts private investment.

In the short-run, sure cutting government spending will contract the economy.

I don't think anyone will dispute that. The question is, how did we get so dependent upon it?

That said, I do buy into the crowding out argument to an extent, but it is secondary.

Anonymous said...

What contracts an economy is having to pay off Keynesian debt at inopportune times.

V said...

Keynesianism is a nice theory, however we always forget the part about raising taxes and saving the surplus in the good times.

When politicians are in charge of the lolly jar, is anyone surprised it is empty just as we need the sugar fix?

faust said...

Peter,

You wrote: "'But for years we were told that cutting govt spending would boost private investment. Remember "crowding out"?'

If you look at Italy, in particular the 10-yr Italian government bond yields, then there is an argument to be made that excessive deficit/debt pushes up government yields crowding out private sector lending.

People talk about Keynes and forget that he was writing during a completely different time where the UK literally had an empire. Trying to apply what Keynes said in a monetary union, with 30 years of continuous government debt expansion and a rigid labour market system is bound to fail.

As a journalist you should know better than to deep-dive for simplistic answers to complex issues.

Post a Comment

COMMENTS ARE CLOSED