Economic Theory

Where is Krugman the economist?


What is striking about Paul Krugman’s recent article in the Guardian criticising the British ‘austerity culture’ is the complete lack of curiosity about the varied and very distinct economic problems that different countries face. Rather than seeing complex problems as an economist might see them, he seems to view them through the prism of a single-issue campaigner.

Unreasonable claims

Not for the first time, Paul Krugman goes beyond the normal limits of economic argument in suggesting: “Meanwhile, all of the economic research that allegedly supported the austerity push has been discredited.” He also argues that austerity is driven at least in part by the interests of big business: “Business interests dislike Keynesian economics because it threatens their political bargaining power. Business leaders love the idea that the health of the economy depends on confidence, which in turn – or so they argue – requires making them happy… The message was clear: don’t criticise big business, or the economy will suffer.” This fails as an argument even at the level of logic. If Krugman is right and more borrowing will help the economy, then confidence will benefit from more government borrowing and business will be happy too.

Many of the key arguments that Krugman makes can be refuted. At the very least the position is far murkier than he makes out.

Britain is not very different from the US and Germany is a silly comparison

Let us take the relationship between fiscal consolidation and growth. Using a very small dataset and highlighting Germany and the US, Krugman argues that the less harsh austerity in those countries compared with the UK led to higher growth. However, between 2011 and 2014, the US significantly reduced its structural budget deficit and enjoyed pretty reasonable growth. It is certainly true that the fiscal retrenchment in the US in 2009 and 2010 was less than that in the UK and that growth there was a little higher. But, US growth in that period was not all that much higher than in the UK, certainly when appropriate adjustments are made for the very different directions in which the UK and US energy sectors were moving. The comparison of the US and the UK basically yields nothing by way of decisive evidence. Germany is just a silly comparison for Krugman to make. In 2010 Germany had a budget deficit less than a third of that in the UK. To compare Britain with Germany in this context is like arguing that there are no great dangers from travelling at 150mph because the increase in speed from 20mph to 22mph yields few extra accidents.

Economics can be complicated

The fact remains that the UK was the fastest growing economy in the G7 in 2014 and we have had extremely buoyant employment growth over a long period of time. However, it is certainly true that output growth has not been as fast as would have been hoped back in 2010. And it is because of these conflicting signals that it is so important that Krugman should put his economist’s hat on and take off his campaigning hat. There are some really important issues to be discussed. Unfortunately, Krugman does not contribute to their discussion in any meaningful sense.

The first of these is whether the effect of austerity in countries with floating exchange rates is different from the effect in countries that have fixed exchange rates or which share a currency. Theory suggests that an economy with floating exchange rates will be affected by austerity much less than one with fixed exchange rates. The reason for this is that capital flows that are necessary to finance high government borrowing raise the exchange rate and choke off private economic activity. If we reduce government borrowing, this can lower the exchange rate and raise private sector activity. A NBER paper in 2010 suggested that this effect was very strong. This might explain why Canada in the 1990s and the UK in the 1980s and 1990s managed to combine reductions in borrowing with strong economic growth despite warnings from Keynesian economists that this would not be possible. It is also the case that what follows for the UK does not necessarily follow for Italy or Germany.

Secondly, employment growth in the UK has been very strong throughout the period of supposed austerity. We have not had strong growth because productivity has declined. It is difficult to think of a Keynesian explanation for this. This scenario cannot be explained by wages being sticky and not falling in recession or by some kind of liquidity trap. Austerity is supposed to lead to a lack of demand, a lack of employment and a lack of output. If Krugman is to have any credibility he needs a Keynesian theory that demonstrates why austerity will lead to low productivity and high employment. Labour hoarding is not the answer given the rate of job creation and destruction in the UK. There are many explanations for low productivity, but none of the important ones fit the Keynesian argument.

Thirdly, Krugman argues: “An economy where interest rates cannot go any lower is an economy awash in desired saving with no place to go.” Yet it is simply not true that the UK economy is awash with savings. It is also not true that private sector interest rates cannot go any lower. The UK household savings ratio is around 6 per cent. That is only enough savings to finance the UK budget deficit, never mind private sector investment. Barely a single penny of private sector investment can be financed by domestic saving. Krugman may not have noticed that the UK has a very large trade deficit. This is not because we are awash with savings which have nowhere to go.

Finally, Krugman seems to show little interest in how a deficit is cut. To Krugman, a pound of aggregate demand is a pound of aggregate demand. However, most economists accept that tax increases reduce growth and productivity – this includes non-Keynesian economists who have a more sophisticated explanation of the events following the financial crisis. Tax increases damage the supply side of the economy. Thus we accept that Osborne’s tax increases were the wrong policy and probably damaged growth. That position is consistent with all the other evidence we see whereas Krugman’s position is not. In fact, only Greece and Ireland out of major EU countries have reduced spending – and the UK certainly did not reduce spending in the early days of fiscal consolidation. A model that does not distinguish between spending cuts and tax increases is not a very worthwhile model.

Krugman is so sure he is right, but what is the counterfactual?

The debates that Krugman believes are settled are certainly not settled. Krugman approaches these complex issues as if he had only a two-dimensional diagram and two curves, one labelled “IS” and the other labelled “LM”, and as if everything had to be solved with this simple apparatus.

At no point does Krugman propose a counterfactual to the policy that was followed. Germany is not an appropriate counterfactual for the reasons explained above. Krugman’s position is that he believes the UK should have increased borrowing from a point where the structural budget deficit was already 8 per cent of national income. The counterfactuals that are available are not very appealing. Greece is one. However, Krugman might argue that there are special circumstances in the case of Greece. Indeed, countries with floating exchange rates and a highly developed financial sector might be better comparators. Japan might fit the bill. And it has to be said that I don’t particularly wish to find myself in a Japanese situation either. About 25 years on from their initial crisis, the government is borrowing 7 per cent of national income and government debt is well over 200 per cent of national income. That is not a nice legacy to hand on to the shrinking future generations. Krugman is a ‘social justice’ campaigner too. But when intergenerational justice meets sledgehammer Keynesianism, we know what Krugman will see as his priority.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.


13 thoughts on “Where is Krugman the economist?”

  1. Posted 30/04/2015 at 12:44 | Permalink

    Philip Booth in his section entitled “Unreasonable claims” clearly doesn’t understand Krugman’s point – and certainly Krugman might have explained it in more detail. So I’ll explain it.

    Krugman is repeating a popular (and very questionable) theory namely that employers don’t like Keynsian stimulus (despite the fact that it would probably raise employers’ profits) because that stimulus reduces employers ability to go running to government with the claim that the increased national debts that derive from such stimulus reduce employers’ confidence. I.e. the theory is that employers don’t like Keynsian stimulus because it reduces what Krugman calls employers’ “political bargaining power”.

    Philip Booth in contrast, assumes the validity of the above mentioned idea that employers ACTUALLY DO LIKE stimulus and the alleged consequent increase in debt because that boosts their profits.

  2. Posted 30/04/2015 at 14:13 | Permalink

    Ralph, thank you for that explanation because if it is true, it is not what Krugman said (as you point out). I was not so much assuming that employers do like stimulus because of the increase in profits. I was saying that IF KRUGMAN IS RIGHT THEN THEY WOULD and therefore they would have no reason to complain. I think – I must admit, I was struggling to understand that point of Krugman!

  3. Posted 30/04/2015 at 14:49 | Permalink

    Employment growth has been very strong. This is an argument that is almost as ludicrous as the 2013 recovery vindicates austerity idea.

    Remember Austerity was carried out until late 2012. Then the economy picked up. Unsurprisingly because Krugman is right about austerity in a depressed economy.

    So for the UK Government try and take credit for strong employment growth despite lack of output growth is to take credit for poor productivity growth (or, in the UK case, the virtual absence of productivity growth over the last five years). Which is very close to wanting to take credit for the lack of growth in real incomes.

    It’s output that matters, not employment. Employment growth due to output growth is good, but employment growth without output growth is not.

  4. Posted 30/04/2015 at 15:38 | Permalink

    agree with that – but what Keynesiam model (except in the very short term and in a job market where labour churn is very low) suggests that you get low demand leads to low productivity? The whole point is that I am arguing that these problems are too complex to fit into a aggregate demand type box

  5. Posted 30/04/2015 at 16:05 | Permalink

    Anonymous – you haven’t provided any explanation of the mechanism there. The poor productivity growth performance over recent years more than explains the poor real GDP performance we’ve seen in the UK. To suggest this is all demand driven and nothing to do with the supply-side seems absurd to me given factors we know about. Also, on this point that the government stopped ‘austerity’ at the end of 2012: the government has barely changed any of their spending or tax plans from 2010. Sure, the pace of consolidation was always slower after the first two years, but that was pencilled in and observable. The only reason the structural deficit was larger than planned was because the productive potential of the economy was revised down and hence the structural deficit revised up. Yet if Krugman was so certain this slower pace of deficit reduction post 2012 would lead to significantly faster growth since (and those are some multipliers if you presume this and not other factors explain it) then why in his early 2013 visit was he still the prophet of doom? I remember him debating a Conservative minister on television at that time, and he certainly wasn’t forecasting an uptick in economic performance.

  6. Posted 30/04/2015 at 17:59 | Permalink

    “It’s output that matters, not employment”

    A thoroughly Thatcherite view of the business cycle, I must say – finally a great Keynesian endorsement of the early 1980s recovery – don’t worry about employment, output growth is what matters.

  7. Posted 30/04/2015 at 18:48 | Permalink

    Okay i understand your point Phillip. I don’t think Krugman pretends its all about demand or that poor productivity is down to lack of demand etc.

    I think productivity is a
    lot to do with the supply side like you guys have said. Maybe Krugman did think it was demand and not supply but i haven’t read that before from his work.

    I agree that lousy Productivity is a reason for weak GDP. And that, in general isn’t the coalitions fault. But that means the Government cannot also take credit for the Good employment figures.

    I concede that I think Paul is a little too combative with those he might have a chance to persuade.

    Given the fact that the coalition essentially stopped imposing new austerity measures after its first two years,(they really did) there’s nothing at all surprising about seeing a revival of economic growth in 2013.

    He is still on the call against austerity because Conservatives are planning to make the same mistake again if they win the election.

    He also points out that Keynesian logic says that a one-time tightening of fiscal policy will produce a one-time hit to the economy, not a permanent reduction in the growth rate.

    So a return to growth in 2013/14 after austerity has been put on hold is not at all surprising.

    He was probably the prophet of doom because the 2013 turnaround 1)didn’t make up for the previous 2 years. & 2) All kinds of people were still suggesting Austerity was working when in fact it had been paused.

    I havent seen that interview but i recall a few ministers spouting economic nonsense about cutting the debt and we will end up like Greece.

  8. Posted 30/04/2015 at 23:44 | Permalink

    Ryan – the fact that the government didn’t revise its tax and spending plans after the deficit was revised up actually vindicates Krugman’s point about there being a deliberate austerity pause. Had the government really believed that austerity was so vital, they would have changed their plans in line with the revision. They would have spent less and taxed more. They didn’t. Obviously the deficit target wasn’t so important after all!

  9. Posted 01/05/2015 at 05:43 | Permalink

    Can we please stop all these lies about austerity. The government is borrowing i believe £150billion give or take every year, households are increasing their credit card debts and total mortgage debt is once again on the increase. In short, we are more indebted than ever. Some austerity?

  10. Posted 01/05/2015 at 10:49 | Permalink

    anonymous, I will let Ryan argue his own points (and your response is far more constructive than Krugman’s arguments!) but I am interested in: “Conservatives are planning to make the same mistake again if they win the election.” When do you think that budget deficits should be reduced? It is one of the highest in the world. It is seven years after the crash (and at the end of the parliament will be 12 years) and employment growth has surprised most people (including me, by the way – I think one reason is that tax credits have created downward flexibility in real wages but I have no evidence). I simply don’t believe that fiscal policy affects growth (so obviously I have completely different criteria from yours). But, if you do believe fiscal policy affects growth, when do you start reining in?

  11. Posted 01/05/2015 at 11:04 | Permalink

    Mark. Your basically right, since 2012, austerity was put on pause.

    Hence the recovery we are having (even though it’s the slowest in 300yrs in real terms.)

    The problem is the Coaltion and even Labour to a lesser extent, are planning to make the same mistake that was made in 2010, in 2015.

    The recovery since 2012 has nowhere near vindicated the damage that was already done by the Coaltion goverment. Conservative estimates suggest at leat 4k per household was lost as a result from Austerity.

  12. Posted 02/05/2015 at 07:56 | Permalink

    when do you start reining in?
    .

    It’s true that you can’t run big budget deficits for ever (although you can do it for a long time), because at some point interest payments start to swallow too large a share of the budget. But it’s foolish and destructive to worry about deficits when borrowing is very cheap and the funds you borrow would otherwise go to waste.

    At some point you do want to reverse stimulus. But you don’t want to do it too soon – specifically, you don’t want to remove fiscal support as long as full on monetary policy is still insufficient. Instead, you want to wait until there can be a sort of handoff, in which the central bank offsets the effects of declining spending and rising taxes by keeping rates low.

    I would argue interest rates need to be high enough so that they can be cut in order to offset austerity. A high target of inflation of around 4% would be a good idea when the economy is in better shape. It could even help erode debt.

    i agree by the way, whether its tax credits or something else, low wages is the main reason for the employment growth!

  13. Posted 02/05/2015 at 19:29 | Permalink

    fair enough points – (even though i don’t agree). But just to add something to the mix, there is the political angle too of it being very difficult in practice to rein in when you want to and certainly to run surpluses. Schumpeter is credited as having said that a dog keeping a sausage reserve is more likely than a government keeping a budgetary reserve (in good times). As the owner of a dog who very rarely gets sausage treats, I found that very amusing.

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