A Nobel-prize winner adrift

I don’t know whether it’s my European blood raging or my dismay with Paul Krugman’s degeneration from an academic I admired to a dogmatic commentator who banks on his economist’s reputation to promote a narrow political ideology.

Krugman’s latest “prey” are European policymakers, in an op-ed piece that is so shallow and uncorroborated in its assertions, and so one-size-fits-all in its prescriptions, that it might have well been written by an American freshman student of European studies in a rush to finish his midterm exam.

EU.bmp Accordingly, European leaders are claimed to have been “slow” and spineless in their reaction to the financial crisis, “poor” in their leadership and full of “know-nothing diatribes” comparable only to those of “well, Republicans.” In fact they have apparently been so slow, poor and know-nothing that the very integration of Europe (and even the euro itself) is at stake.

Let’s start with monetary policy and the ECB, who “completely missed the depth of the crisis”, is still “complacent” and (always per Krugman) basically lacks the balls and/or the government backing to follow the Fed in its bold, resolute steps.

Perhaps a few facts might help here, in lieu of the colorful charges above.

Complacent? The ECB was the first to act back in August 2007 upon the first signs of funding pressures and liquidity hoarding by banks. It did so by providing banks with ample amounts of liquidity at longer maturities. A year later, when the (real) fireworks began, the ECB expanded its support measures by providing unlimited liquidity with maturities of up to six months, and by expanding considerably the list of eligible assets that banks could pledge as collateral.

As a result of these measures, the ECB’s balance sheet increased by 600 billion euros compared to its pre-crisis level. This is about 6% of eurozone GDP, which, actually, is almost the same as the Fed’s own balance-sheet expansion in GDP terms! Critically, Trichet has by no means signaled the end here. Au contraire!

“Shied away from any strong measures to unfreeze credit markets”? Given the above, I take it that by “strong measures” Krugman refers to the likes of the TALF or the MBS purchase program—i.e. measures taken by the Fed to bypass the banking system and support targeted dysfunctional credit markets directly (e.g. housing or credit card loans, auto loans, etc).

The ECB has yet to go that far and for a good reason. Bank-based lending is far more predominant in Europe than in the US, where capital markets play a substantial role in allocating credit. Addressing any dysfunctions in the banking sector in order to jumpstart bank lending is therefore of utmost importance in Europe, with TALF-like measures only secondary.

In fact, I would go as far as to suggest that restoring bank health is as important in the US (see here why) and any thought that the TALF could help revive credit by bypassing the US banking system is wishful thinking.

Slow (in cutting rates)? Possibly, but the facts don’t really prove the superiority of the Fed’s bolder approach either. For all its whopping rate cuts, the Fed has not succeeded in loosening financial conditions in the US in a meaningful way. (See here again).

Three-month Libor rates in Europe are only 0.30% higher than in the US, despite the ECB’s policy rate being 1.25% higher than the Fed’s. US yields on long-term corporate debt came off their October peaks but have subsequently resurged amidst the ongoing uncertainty in financial markets. The Fed’s announcement that it would start purchasing Agency mortgage-backed securities (MBS) brought MBS yields sharply down in late November. But mortgage yields have edged up again since mid-January, partly on concerns that the US Treasury’s fiscal “adventures” might lead to inflation in the future.

Completely missed the depth of the crisis? Perhaps. But it looks like the ECB was in good company. Here is a quote from Ben in the FOMC statement of August 7, 2007—the very onset of the crisis (sorry Ben!):

“Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.” (My emphasis).

And on June 25, 2008: “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.”

Coming on to fiscal policy, the “know-nothing” diatribes of the German finance minister, and Europe’s “striking” hesitance to match America’s audacity. I’ll leave aside the “know-nothing” criticism, although I can’t help noting that I have yet to hear any words of wisdom from our own Treasury Secretary. I’ll also refrain from debating the desirability of a stimulus package of the size and shape approved by the US Congress. *The* point here is that it’s ludicrous to claim that European governments should follow the US Treasury’s footsteps, without stopping to think whether they can afford to.

Unlike the US Treasury, which can (still) issue 10-year notes at a 3% yield, long-term yields are materially higher in some European countries, reflecting fiscal vulnerabilities that could only be exacerbated by further debt burdens. As to Germany, which could arguably “afford to” increase its stimulus, it has potentially a lot on its plate. Germany would be one of the few European countries that could muster sufficient resources to provide emergency bilateral support to a fellow EU country experiencing a sudden loss of investor confidence (The IMF could be another source of support, provided its resources are replenished fast).

Would the likes of Germany do it? Anyone who doubts any eurozone member’s commitment to integration and the euro itself has zero understanding of the interconnectedness that has made European integration a necessity.

From the perspective of weaker countries, the currency stability and relatively low yields (even during this crisis) are just one demonstration of the immense benefits of such integration. The fact that some Eastern European members are now knocking on the door for a faster eurozone membership is a further confirmation. As to Germany, the bulk of its trade surplus remains with Europe and the currency devaluations that would likely follow a euro break-up would destroy the growth model it has been benefiting from for years.

Talking about boldness, the euro has been one of the boldest policy measures in recent economic history. And if Krugman wants to talk seriously about currency crises, he’d better go back to the drawing board and write a paper of the caliber that showed his genius back in 1979. Otherwise I recommend a year off in Brussels. They have good beer!

Originally published at the Models & Agents blog and reproduced here with the author’s permission.

5 Responses to "A Nobel-prize winner adrift"

  1. Anonymous   March 20, 2009 at 2:57 am

    I start to think that Krugman does not know anything about Europe. In his “Spanish doldrums” in NYT he writes also “And one has to say that Europe has gotten itself into one heck of a mess, worse even than ours — because they have intractable adjustment problems on top of the general crisis”.It appears that he is pursuing a political agenda but have little knowledge of Europe if he continues to write along these lines as non economists (we all remember his unsubstantiated comments against Germany and was accused of crass Keynesianism). The only real mess Europe got into is to invest in US made financial products and/or lend US some money together with Asian countries. The recession in Europe would have been much different if that had not happened. A sin of European bankers although from the AIG list of counterparts it appears that European institutions were on the right side of the bet and got to be paid. Moreover, UK and Spain are just two countries with housing and construction sectors bubbles, American style. The rest is just finance mess made in US blocking the functioning of credit markets and flowing of money.On my blog http://mgiannini.blogspot.com/2009/03/my-name-is-bond-european-union-bond.html, I also made the case again for the issuance of EU bond, which not only would improve European integration and coordination but, also rival the US dollar denominated securities and reserves. It will be a big blow to economists like Krugman, Euro skeptics. Time is just right!

  2. Robert Shelburne   March 20, 2009 at 3:12 am

    This article makes some worthwhile points but the basic conclusions of Krugman remain correction. Now, as over the last decade, European macroeconomic policy has been poorly implemented due to design defects in European institutions, especially the ECB, and a strange political attachment to essentially neoclassical economics.

    • Guest   March 20, 2009 at 3:39 am

      “basic conclusions of Krugman remain correct”? “poorly implemented”? Are you a Krugman’s student?

  3. Anonymous   March 20, 2009 at 7:20 am

    Krugman is surfing on his past reputation. The central question is whether Germany can change its economic thinking – its “growth model” – i.e. not assume that demand must always come from outside its own borders. A start could be made by living up to the EU obligation to allow free movement of workers from the former Eastern Europe. There is no sign of this happening before the final dates agreed in the context of Enlargement i.e. 2011/2013.The alternative is to promote an economic recovery in Germany’s “tied market” i.e. the rest of the EU.Germany cannot have it both ways. The outcome of the current European Council meeting suggests that the penny is beginning to drop.The other question of great interest is the three way split between the Eurozone/UK/other Member States. The UK is trapped half-way between the US and Europe while those countries outside the Eurozone will have to take what they can get. Not that Germany is happy with the behaviour of some Member States who gained membership from the start but it has no alternative but to protect the integrity of the system. The single currency is the obvious concomitant of the internal market of which Germany is without a doubt the greatest beneficiary.

    • Guest   March 25, 2009 at 4:31 am

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