Where is Krugman the economist?
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.