Paul Krugman's Verdict Is In – And It's Wrong
Given that Paul Krugman supports a failed economic theory, we tend to strongly doubt his pronouncements on economic issues. In a recent NYT editorial, entitled 'When Austerity Fails', Krugman delivers his verdict on the austerity efforts of the European periphery. The point of his jeremiad is to persuade US politicians to keep up the deficit spending. Denouncing what he calls the US 'pain caucus' (i.e., those politicians trying to show some sense of fiscal responsibility) Krugman writes:
“In Europe, by contrast, the pain caucus has been in control for more than a year, insisting that sound money and balanced budgets are the answer to all problems. Underlying this insistence have been economic fantasies, in particular belief in the confidence fairy — that is, belief that slashing spending will actually create jobs, because fiscal austerity will improve private-sector confidence.
Unfortunately, the confidence fairy keeps refusing to make an appearance. And a dispute over how to handle inconvenient reality threatens to make Europe the flashpoint of a new financial crisis.”
We agree the risk of another crisis, or rather the risk of the existing debt crisis in the euro area worsening is very high. The euro is a flawed currency, and the ECB has an especially big problem trying to centrally plan the monetary policy for the disparate euro area economies. Should political discord lead to e.g. Greece dropping out of the euro area, the financial damage could be far-reaching and vast, not least because contagion would become a big issue. However, Krugman doesn't let us in on how exactly even more deficit spending by de facto bankrupt governments could possibly improve the situation. The truth is of course that it wouldn't. Would Krugman's vaunted 'confidence fairy' be likely to make a sudden entrance if Greece's debt-to-GDP ratio were (hypothetically) to rise to 200% or 300% instead of to 160% as it is likely to do next year? We think not.
In fact, more deficit spending isn't even possible for bankrupt governments – luckily. We would therefore retort that for the concerned nations, doing something about their debts is far better than to just continue spending willy-nilly – which is what Krugman recommends the US government should do. In addition, Krugman makes a mistake that strikes us typical for supporters of Keynesian deficit spending recipes. He looks at what has happened in one year and insists that the observations made in such a short time span are sufficient to judge whether the austerity policy is likely to bring about the desired results. How did the Asian economies get out of the 1997/98 crisis? We seem to dimly recall that they all introduced austerity measures and that it took a good while for the positive results to become manifest. So let us explain again how this works for the Krugmans of this world: once a major malinvestment bubble bursts, the economy is in dire straits. This state of affairs can not be improved by more deficit spending and inflation, even though such policies may appear to work in the short term. However, this is nothing but an illusion – in the long term they merely postpone and worsen the underlying problems. The Great Depression and Japan's slow-motion depression – both eras in which big government/big deficit spending solutions utterly failed – seem far more pertinent as far as empirical evidence goes than what has happened in just one year of euro area austerity.
“After the creation of the euro in 1999, European nations that had previously been considered risky, and that therefore faced limits on the amount they could borrow, began experiencing huge inflows of capital. After all, investors apparently thought, Greece/Portugal/Ireland/Spain were members of a European monetary union, so what could go wrong?
The answer to that question is now, of course, painfully apparent. Greece’s government, finding itself able to borrow at rates only slightly higher than those facing Germany, took on far too much debt. The governments of Ireland and Spain didn’t (Portugal is somewhere in between) — but their banks did, and when the bubble burst, taxpayers found themselves on the hook for bank debts. The problem was made worse by the fact that the 1999-2007 boom left prices and costs in the debtor nations far out of line with those of their neighbors.”
This is correct. The sudden lowering of interest rates in the euro area's periphery as a result of interest rates converging to German levels brought about many unintended results. What Krugman fails to mention in this paragraph is that when the tech bubble burst in 2000, he and his fellow travelers of the Keynesian faith advocated precisely the policies (namely, slashing interest rates to the bone and engaging in more deficit spending) that brought on the unsustainable boom the end result of which he now bemoans. He continues:
“What to do? European leaders offered emergency loans to nations in crisis, but only in exchange for promises to impose savage austerity programs, mainly consisting of huge spending cuts. Objections that these programs would be self-defeating — not only would they impose large direct pain, but they also would, by worsening the economic slump, reduce revenues — were waved away. Austerity would actually be expansionary, it was claimed, because it would improve confidence.
Nobody bought into the doctrine of expansionary austerity more thoroughly than Jean-Claude Trichet, the president of the European Central Bank, or E.C.B. Under his leadership the bank began preaching austerity as a universal economic elixir that should be imposed immediately everywhere, including in countries like Britain and the United States that still have high unemployment and aren’t facing any pressure from the financial markets.”
Again, how would increasing these unsustainable deficits have improved confidence? Krugman doesn't say. As to 'worsening the economic slump' – when the government doesn't interfere, or at least reduces its interference, with in the economy after a boom comes to its end, things will always be painful in the short term, as the liquidation of the capital that was misallocated during the boom is set into train. However, why should keeping malinvested capital on artificial life support be any better? Just because it is less painful in the short term, doesn't mean it is the correct policy to pursue. Not if one wants to fix the underlying structural problems. That requires austerity – and yes, short term pain, sometimes lots of it, commensurate to the wealth-destroying boom that preceded the bust.
“But as I said, the confidence fairy hasn’t shown up. Europe’s troubled debtor nations are, as we should have expected, suffering further economic decline thanks to those austerity programs, and confidence is plunging instead of rising. It’s now clear that Greece, Ireland and Portugal can’t and won’t repay their debts in full, although Spain might manage to tough it out.
Realistically, then, Europe needs to prepare for some kind of debt reduction, involving a combination of aid from stronger economies and “haircuts” imposed on private creditors, who will have to accept less than full repayment. Realism, however, appears to be in short supply.”
Confidence is currently in short supply, especially among holders of peripheral government bonds, there can be no doubt about that. It also seems extremely likely that in the end, Greece's creditors will have to agree to some sort of debt restructuring, and the same fate likely awaits Ireland's and Portugal's creditors. We agree that the eurocracy is unrealistic and seems increasingly unsure of how to handle the problem. Dissent within the euro area is growing, as the social mood deteriorates and political incumbents everywhere are facing the prospect of losing elections. Alas, none of this proves that austerity won't work for the economies concerned. In fact, it appears it has worked in the Baltic nations. They kept their euro pegs, and one of them, Estonia, implemented such a harsh austerity regime that the country was able to join the euro late last year by fulfilling the criteria of the stability pact. Its economy is slated to grow by 5.9% this year. Its fiscal deficit in 2011 will be 0.5% of GDP. How about that? Apparently Estonia has managed to achieve what according to Krugman is 'impossible'. Lithuania and Latvia are close behind, with Lithuania's growth expected to hit 5.6% this year and Latvia's expected to hit 4%. Latvia's economy shrank by 25% when the impoverishment of the boom was unmasked. All these nations have implemented strict austerity measures and vastly reduced government indebtedness – now they are back on a solid growth path. According to Krugman, this is not possible, which may be why he has so far somehow neglected to mention it.
“On one side, Germany is taking a hard line against anything resembling aid to its troubled neighbors, even though one important motivation for the current rescue program was an attempt to shield German banks from losses.
On the other side, the E.C.B. is acting as if it is determined to provoke a financial crisis. It has started to raise interest rates despite the terrible state of many European economies. And E.C.B. officials have been warning against any form of debt relief — in fact, last week one member of the governing council suggested that even a mild restructuring of Greek bonds would cause the E.C.B. to stop accepting those bonds as collateral for loans to Greek banks. This amounted to a declaration that if Greece seeks debt relief, the E.C.B. will pull the plug on the Greek banking system, which is crucially dependent on those loans.”
German politicians are under a lot of pressure – but for all their tough talk, they have so far fully supported the bailout measures – precisely because they want to protect Germany's (and not only Germany's) banks. As far as the ECB's threat goes – the ECB wants to do the same – protect the creditor banks, including itself. As long as it can be pretended that bonds that trade at a 50% discount to par can be redeemed at par, the ECB can continue to provide life support to the banking systems of the peripherals, which would otherwise have to declare their insolvency. Consider the following chart, which shows the extent to which the ECB provides funding to these banks.
The funding of euro-area system central banks in the peripheral countries to their banking systems. These banks are unable to tap the interbank funding markets and have hawked their government bond holdings (inter alia) to the ECB to cover their funding needs. Chart via Der Spiegel magazine – click for higher resolution.
“If Greek banks collapse, that might well force Greece out of the euro area — and it’s all too easy to see how it could start financial dominoes falling across much of Europe. So what is the E.C.B. thinking?
My guess is that it’s just not willing to face up to the failure of its fantasies. And if this sounds incredibly foolish, well, who ever said that wisdom rules the world?”
The Greek banks are de facto insolvent, as are their brethren in Ireland and Portugal. If they had to mark their government bond holdings to market, their capital would be largely wiped out. The ECB is attempting to prevent a domino effect from occurring, not trying to bring it about. It is trying to keep up the charade that these bonds are still worth their face value – its threat is meant to keep the idea of debt restructurings at bay. Krugman however fails to mention what this really shows us: a fractionally reserved banking system that is free to inflate its deposit liabilities into the blue yonder is prone to failure. Once a country gives up its money printing press but takes no steps to rein in credit and money supply inflation by inflationary bank lending, the failure will become very much apparent once a boom ends. So why is Krugman not manning the barricades in favor of 100% reserve banking?
Now let us take a look at Greece. In what looks like a slightly overoptimistic official report (pdf), the Greek government has enumerated the achievements of the austerity plan to date and what it expects from the next round of measures it is about to implement. What is interesting about this report is that a number of the underlying economic data have begun to subtly improve of late – which once again according to Krugman should not be possible. Could Greece be about to pull an Estonia on Krugman? He'd have some explaining to do if that were to happen (our bet is he would simply conveniently forget to ever mention it again).
Greece's GDP statistics – it may be a bit early to judge, but it appears at the moment that the trough of the economic contraction was reached in qu. 4 of 2010 – click for higher resolution.
Year-on-year growth of Greek exports – one of the bright spots in the economy in recent quarters – the current account deficit is shrinking accordingly. This is a sign that competitiveness has improved – click for higher resolution.
The markets continue to price in a Greek default however – which has reduced euro area bankers holding exposure to Greek debt to 'closing their eyes and hoping', as Reuters reports:
“European banks remain saddled with almost 100 billion euros of Greek government debt they can't sell, hedge or ignore, after a number of recent deals to offload the exposure to reduce the impact of a possible default ended in failure, according to bankers involved.
The deals have been thwarted by a lack of willing buyers for the debt — even at record low prices — and that exposed lenders have been unable to buy protection because of the high costs, with top bankers advising their clients all they can now do is cross their fingers and hope for the best.
"The vast majority of these banks have just been unable to do anything," said one European banker who has advised dozens of such banks. "Protection is too expensive, and markets for these bonds are illiquid, so many are riding out the problem. Right now, all they can do is shut their eyes and hope."
Greek domestic banks are by far the biggest holders of the country's bonds with some 50 billion euros of exposure, according to a handful of estimates. But another 50 billion is held at banks outside the country, with German banks alone exposed to around 19 billion of the paper, while French banks hold another 15 billion.
Fitch Ratings said on Wednesday that is sees high potential contagion risks from any restructuring of Greek debt. In a report on the German banking industry, Fitch said there would be a "sharp increase in general capital market and creditor risk aversion" if such an event were to take place, but added that it does not envisage ratings action on the lenders.
"For a lot of banks, their worst nightmare seems to be coming true," said another investment banker who advises financial institutions on the continent. "We now know that the Greek smoke was indeed fire and a lot of people have now found themselves heavily exposed."
It's the denouement of a once-popular carry trade that has fabulously backfired. Tempted by easy profits — Greek debt paid slightly higher interest than similarly-rated German paper — lenders from across Europe bought up the bonds through most of the last decade to hold as part of their mandatory capital buffers.
Such was the demand that the spread between Greek and German 10-year government bonds fell to about 20bp in 2004 — down from more than 150bp five years earlier. That trend has now reversed, with a drop in the price of Greek debt pushing the spread to more than 1,400bp this week.
"Many banks would have looked at these bonds as liquid, zero-risk assets," said Tim Skeet, a financial institutions banker at RBS. "When you're putting together a liquidity buffer you need to look for something that offers a bit of yield, and these bonds did just that. There was a sensible rationale for buying this stuff."
This sound suspiciously like the speculation in the once AAA rated senior tranches of mortgage backed CDO's produced by US investment banks. The 'hunt for yield' has once again tripped up the bankers. Greece's 2 year note yield continues to hover near its recent highs:
The Greek 2 year note clocks in at 26.02% presently, slightly below the highs reached a short while ago – click for higher resolution.
Contagion risk remains very high, as for example Irish government bond yields have just broken out to new highs, while Portugal's bond yields are back at the highs seen earlier this month:
Ireland's 10 year government bond now yields 10.99% – a new high – click for higher resolution.
Portugal's 10 year yield at 9.73% is very close to its recent highs – click for higher resolution.
The most important bond yield to watch in the euro area however remains that on Spanish government bonds. This yield still remains in the somwhat elevated trading range established in the course of this year, but unfortunately for Spain, this looks like a potentially bullish (bearish for bond prices) consolidation:
Spain's 10 year yield sits at 5.335%, a tad below the upper boundary of this year's range. Should this yield break out to new highs, the debt crisis would surely enter a new phase – click for higher resolution.
The main reason why there are doubts about the Greek austerity program in the markets is that it remains doubtful that the it can be continued without provoking an escalating political backlash. The Greek opposition has recently refused to endorse the continuation of the program using the Krugman argument: 'it's not working':
“The leader of Greece's conservative political opposition on Tuesday rejected the government's new package of fiscal measures to slash deficits, saying it would not help the economy to recover.
"I am not going to agree to this recipe which has been proven wrong," New Democracy party leader Antonis Samaras said after a meeting with Prime Minister George Papandreou.
The government enjoys a comfortable majority in parliament but Papandreou is seeking wider political consensus before taking additional austerity measures to exit a debt crisis.”
Austerity is deeply unpopular and the Greek opposition wants to make sure that the blame for the unpopular policy is pinned on the current government. This does not mean that it would do anything differently if it were to come to power. It is also a stance that could potentially backfire if Krugman turns out to be wrong and the economy recovers.
The debt crisis in the euro area so far continues unabated. Bondholders remain unconvinced that the existing debt of the three so far 'bailed out' nations will be paid back in full. We would submit that the problem is that the fractionally reserved banking systems in these countries have vastly expanded circulation credit during the boom. Concurrently, governments increased their spending as the lower interest rate structure of the common currency combined with the artificial increase in boom-time tax revenues wrongly made it appear that more fiscal spending was affordable. When the bust struck, it suddenly turned out that governments and banks both were in hot water. In the wake of the 2008 crisis it was decided that insolvent banks would be bailed out at the expense of taxpayers, worsening public balance sheets commensurately. The probability that the debt crisis will continue to worsen remains extremely high at present. Spain's and Italy's potential problems may well be underestimated at this point in time, while the three peripherals subject to bailouts are likely to eventually be forced to restructure their debts. The euro-area's banks remain in danger of potentially facing cascading cross-defaults should the crisis take a marked turn for the worse in the near future. Since 'stealth defaults' via the central bank's printing press are out of the question for the member nations of the common currency area, the main question remains who shall eventually bear the losses. A worsening of the crisis could easily upset the plans for improving the economic conditions in the peripherals. The true culprit of the boom-bust cycle remains beyond the pale of official debate, and until that changes, the problems are likely to recur. In the short term considerable danger remains, as bond markets keep deteriorating and the probability of another synchronized global downturn is rising due to tighter monetary policy being implemented elsewhere in the world. There is no question that risk is very high.
However, none of this provides proof for Krugman's contention that a policy of austerity is the 'wrong thing to do'. On the contrary, it is the only policy that has a remote chance of restoring the economies concerned to a healthy footing. Krugman willfully ignores the evidence from the harsh austerity programs pursued in the Baltic nations – which were the first nations forced to adopt such measures as they simply had no other choice. What is notable about their example is that they steadfastly kept their currency pegs to the euro in place and allowed internal deflation to restore their competitiveness. Was it bitter medicine? There can be little doubt that it was. And yet, if Krugman and other economists favoring Keynesian deficit spending were correct, then economic recovery should not have been possible. Perhaps Krugman can remind us when the biggest deficit spender on earth, Japan, last produced growth rates between 4% to 5.8% annualized? In the Baltics, it took three years from the beginning of the bust to get to that point. How long will it take for that poster boy of Keynesian deficit spending policy, Japan? So far we're at 21 years and counting.
Charts by: Bloomberg
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