by Anders Aslund, Peterson Institute for International Economics
Op-ed in Foreign Policy. Reposted with permission.
November 8, 2013
© Foreign Policy
Few have written more about the European financial crisis since 2008 than the Nobel laureate, New York Times columnist, and Princeton economics professor Paul Krugman. After five years, it is clear that the euro area has survived contrary to his predictions, and the countries that pursued fiscal discipline, contrary to Krugman's advice, have done better—both economically and politically—than those that did not.
Since Krugman represents the mainstream of Anglo-American economic commentary and enjoys both popularity and an impact on policy, a post mortem of his positions on the European financial crisis are of broader relevance. The problem is not the odd flawed prediction—everybody makes such mistakes—but an unhelpful thinking about fiscal policy of which Krugman is the prime representative.
I was first struck by Krugman's misperception of the European financial crisis back in December 2008, when he wrote a blog post that baffled me. It was titled: "Latvia is the new Argentina." The comparison was bizarre. Argentina is a large, closed economy that has mostly pursued populist economic policies, while Latvia is a very small, open economy, [pdf] and a member of the European Union with low public debt and an excellent business environment. The only similarities were financial crisis because of large current account deficits leading to an absence of market financing.
Based on this facile analogue, Krugman concluded that Latvia would then have to devalue as Argentina had, but of course that didn't happen. The Latvian government ignored his advice. It stuck to its peg to the euro and carried out a draconian fiscal adjustment, which quickly restored confidence and prompted plenty of structural reforms; it is now the fastest growing economy in Europe. Krugman's mistake was to look at only a couple of indicators and draw a simplistic analogy.
Krugman's most spectacular failure has been his prediction of the dissolution of the euro area. As Niall Ferguson has noted, Krugman "wrote about the imminent break-up of the euro at least eleven times between April 2010 and July 2012." Well, that didn't happen. Not only did the euro area remain intact, but Slovakia joined in 2009, as did Estonia in 2011; Latvia is set to join in January 2014.
While anyone can make a mistake, Krugman's error was more profound, indicating a lack of understanding. He treated the euro area as primarily a system of fixed exchange rates, ignoring that it is a currency union with centralized clearing of payments. As the euro crisis evolved, uncleared payment balances piled up. The best way of dissolving these imbalances was by restoring confidence in the euro system, which the European Central Bank (ECB) has done, sensibly, since July 2012. A breakup of the euro area, on the other hand, would have resulted in large debts and claims of the various members, leading to major financial destabilization.
In the last century, three multinational currency unions in Europe have endured disorderly breakups—namely the Habsburg Empire, Yugoslavia, and the Soviet Union. In each case, the outcome was multiple hyperinflations from which several countries have still not recovered two decades later. To my knowledge, Krugman has never mentioned this aspect in print. Nor was it self-evident that the European Union and its single market would survive if the euro system broke up. This was truly unchartered territory. However, ECB President Mario Draghi did understand the dangers, and in July 2012 he declared that the ECB would "do what it takes" to save the euro. And while Krugman advised against saving the euro, he had (rightly) praised the "do what it takes" philosophy.
When it comes to fiscal policy, Krugman is single-minded in his focus on aggregate demand rather than supply, seemingly unaware of how constrained supply has been in the European Union, not least because of overregulated labor and service markets. He has persistently favored fiscal "stimulus," larger budget deficits, and slower fiscal adjustment. Today, the record is clear. The countries that have followed his advice and increased their deficits (the South European crisis countries) have done far worse in terms of economic growth and employment than the North Europeans and particularly the Baltic countries that honored fiscal responsibility.
Luckily for European democracies, the ultimate verdict on crisis management belongs to the voters. During the five years from October 2008 until September 2013, eight EU governments—in Estonia, Finland, Germany, Latvia, Luxembourg, the Netherlands, Poland, and Sweden—have been reelected, hanging onto power even in the face of economic crisis. These governments were the ones that pursued responsible fiscal policies, often called austerity, contrary to the policies Krugman prescribed. Apparently, large budget deficits are not very popular with voters. In 2012, the average budget deficit of these eight countries was 1.6 percent of GDP, compared with 4.8 percent in the 19 countries where the governments have been ousted. The voters seem to have got it right. The economies of the eight virtuous countries grew by 1.4 percent, while the economies of the 19 others contracted by 0.8 percent.
If we examine the reasons for this outcome, it does not appear surprising. The only economic argument for a slow fiscal adjustment is that the fiscal multiplier, that is, the ratio of change in national income to the change in government spending, might be uncommonly large in the first year (as the International Monetary Fund [IMF] has claimed in one research paper, [pdf] though in the literature there's no clear-cut agreement that the fiscal multiplier is so great). Moreover, five years after the bankruptcy of Lehman Brothers, we are no longer talking about the short term of one year but the long term of five years.
Many more arguments favor an early fiscal adjustment—namely that financing is often not available, that European countries needed to trim their public expenditures, and that Europe's key problem was structural. Krugman's problem is not his view on these issues but that he persistently ignores them as if they did not matter. In his world of economics, little matters but aggregate demand.
For many countries in jeopardy, international financing is not available. Since the average public debt in the European Union had risen to 91 percent of GDP in 2012, hardly any country but Luxembourg and Sweden had fiscal space to pursue fiscal stimulus. Among the 28 EU countries, no less than eight needed international financial assistance not available to them on the market—Hungary, Latvia, Romania, Greece, Portugal, Ireland, Spain, and Cyprus. Therefore, fiscal stimulus was not an option because bond yields and interest rates had surged sharply and surprisingly.
In late 2008, for example, Latvia and Romania lost market access when their public debt was less than 20 percent of GDP, showing how minimal their fiscal space was. Yet Krugman ignores that many small countries find it difficult to raise international financing in times of crisis.
Krugman's persistent pleas [pdf] for more fiscal stimulus presumably contributed to the IMF pushing countries such as Spain, Slovenia, and Cyprus to increase their budget deficits impermissibly to about six percent of GDP, far more than they could finance, in 2009. After these countries had expanded their budget deficits, they could not cut them, which is not very surprising. This raised their bond yields and put them into financial hazard.
All European countries have excessive public expenditures that need to be trimmed because they harm economic growth, which Krugman refuses to acknowledge. To his horror, the Baltic countries carried out a fiscal adjustment that consisted of two-thirds expenditure cuts and one-third higher taxes. The southern Europeans, by contrast, mainly raised taxes, which Krugman was less opposed to. As a consequence, even in 2012 Greece had 55 percent of GDP in public expenditures, significantly more than Sweden (52 percent) and far too much to allow significant growth. Obviously, Greece should have cut expenditures faster to promote growth.
The key European problem, which Krugman persistently ignores, has long been constrained supply because of poorly functioning markets for labor and services, which led to low growth before the current crisis. Front-loaded fiscal adjustments made ample structural reforms necessary in the Baltic countries and Bulgaria and caused great economic growth in the Baltic countries, while Greece has only recently started undertaking significant structural reforms. Major structural changes are both necessary and appreciated. Latvia cut public wages by 26 percent in 2009 and sacked 30 percent of its civil servants in 2009 without any public protests, while public unrest was ample in Greece until the government started sacking civil servants. In the last year, it has been minimal.
What Krugman refuses to see is that front-loaded fiscal adjustment quickly restores confidence, brings down interest rates, and leads to an early return to growth. Thanks to greater structural adjustment, the growth trajectory is likely to be higher in countries that quickly and enthusiastically embrace these reforms than elsewhere. Accordingly, the three Baltic countries that suffered the largest output falls at the outset of the crisis because of a severe liquidity freeze returned to growth within two years and have, over the same period, enjoyed the highest growth in the European Union. By contrast, Greece, with its back-loaded fiscal adjustment, as recommended by Krugman, has suffered from six years of recession.
Krugman also worried at length about the risk of a "competitive deflation" because of large wage cuts. But deflation has hardly occurred anywhere in Europe. Even in Latvia, where unit labor costs in the whole economy declined by 25 percent in 2008–09, consumer prices fell by just 1 percent in 2009. Part of the explanation is that productivity in Latvian manufacturing rose by an extraordinary 50 percent in 2008–11, thanks to an early and radical fiscal adjustment and impressive structural reforms. [pdf] The evidence points to the success of these measures; Krugman just refuses to see it.
Throughout the European financial crisis, Krugman has provided poor advice on how to pursue fiscal policy. The successful EU countries recovered by doing the opposite of what he recommended—while those governments that followed his advice on slow and back-loaded fiscal adjustment, or even fiscal stimulus, have failed miserably. During five years of extensive writing on the EU financial crises, Krugman advocated depreciation but maintained that pegged exchange rates worked perfectly well. [pdf]
Contrary to his predictions, the euro area has survived. He advocated fiscal stimulus, but rapid fiscal adjustment turned out to be the best cure for both public finances and economic growth. He ignored the fact that all EU countries had excessive public expenditures and needed structural reforms. Nor did he understand the general mood of Europeans, as clearly expressed by their electoral preferences, though that didn't stop him from expressing strong views to the contrary. And he has favored social democracy, which European voters have widely rejected to the benefit of the moderate center-right, which has never been stronger.
The reasons for his misperceptions of European economic policy are manifold. Krugman did not look upon the relevant variables and ignored all but a few facts. He adhered to a simplistic macroeconomic view that more fiscal stimulus is always better, which should make poor John Maynard Keynes turn in his grave. It's hard to overcome the suspicion that Krugman actually had the United States and its problems in mind when he was writing about Europe. The real problem is that these two parts of the world are quite different.