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By Dr. Jim Leontiades
Cyprus International Institute of Management
Paul Krugman, the Noble Prize winner has written a new book which questions the wisdom of the economic austerity policies frequently prescribed by the troika.* The main theme of the book is very simple. The current financial crisis in both Europe and the USA is unnecessary. The pain, loss of jobs and privation which it has inflicted in much of the world need not have been. Krugman’s message could not be more timely, particularly for Cyprus.
Characterised by exceptional clarity, Krugman’s exposition unfolds like a morality play – almost as a battle between good and evil. The central issues being contested are the effects of government debt and spending during financial crises. The writing is punctuated with quotes and evidence on both sides (although there is seldom any doubt on which side he is on).
Lessons Forgotten
Why have we not understood the lessons of the past? Why have we failed to learn from experience, the most obvious being the great depression of the 1930s. As regards economic theory, Krugman places much of the blame on the “perfect markets school”. According to economists such as Eugene Fama and Alan Greenspan, recessions were not supposed to happen.
This “Panglossian” view of the world , says Krugman, cannot explain the basic fact that recessions do happen. They are more than just temporary anomalies intruding on the perfectionist tendencies of markets. Krugman’s thesis is that Keynes, the English economist, offers the only theoretical framework that even addresses the problem of recessions and offers a cure.
The key phrase is the following: “When, there is deficient demand and interest rates are close to zero (the liquidity trap) the effectiveness of monetary policy tools is limited. Government should step in and make up for the spending that the private sector is not supplying even if this means government borrowing and debt. Tax increases and spending cuts during a period of depressed demand will depress it even further.”
Managing National Debt
In both Europe and the USA it became fashionable during the early stages of the current financial crisis to issue apocalyptic warnings on the dangers associated with increases in national debt.
“The enormous increase in bank reserves, caused by the Fed’s purchase of bonds and mortgages …will surely bring on severe inflation if allowed to remain.” Allan Meltzer monetary economist, May 2009.
Niall Ferguson, noted Harvard economics professor: “the effect of Keynesian policy must be to drive interest rates up.” April 2009
Writing two and one half years later, Krugman finds that average inflation in the USA over the period had been 2,5%, omitting food and energy, it has been 1.4% . He acknowledges “it is possible that printing money can cause inflation, if it leads to higher spending and a boom. But until then, ‘no boom, no inflation’. ”
Increases in national debt are no problem “as long as it grows more slowly than the sum of inflation and economic growth”. The national debt of Japan is over 200% of GDP and the USA national debt during WWII was a much higher percent of GDP than it is today.
The Euro zone
Krugman concedes that the overall debt burden can be a problem, but the problem is different for different countries. Greece is an example of the sort of profligacy and corruption that has to be addressed directly. There is no option here but to cut back on public spending and to reduce debt. But Greece is an exception in Europe. The average debt of the other Euro zone peripheral countries was in fact manageable and declining before the crisis. The austerity policies prescribed by the Euro zone in a recession reduces demand, making things worse.
An additional problem unique to the Euro zone is that member countries no longer control their own currency. They are not able to support their own sovereign debt on the open market by printing money in the manner of USA, UK and Japan. It is difficult for them to engage in debt financed government spending, to make up for the drop in private spending as prescribed by Keynes/Krugman.
Not surprisingly, the author has little sympathy for current Euro zone officials (which he refers to as “austerians”) and their policies. Reducing national debt is central to their approach. The view as, expressed by several EuroZone officials, is that reducing national debt for countries in this situation increases confidence. Krugman calls this “the confidence fairy”. It is not supported by the evidence.
His Keynesian approach for dealing with the current financial crisis is almost the exact opposite of that currently followed by the troika. Krugman believes there is a time when addressing the issue of debt reduction is appropriate but that time is not when countries are on the brink of recession. The present financial crisis provides a test of the two views, a social laboratory. Some years from now, we will have a better idea of which is the better prescription, though it will then be too late for many.
*Paul Krugman, End This Depression Now! (W.W. Norton & Co, NY, NY. 2012).
