Periphery Macroeconomics and Paul Krugman: Correct Diagnosis but his Policy Recommendation Does Not Go Far Enough

How should monetary and fiscal policy be set to create economic growth without increasing public debt? This column disagrees with the ‘European view’ supporting austerity and agrees with the ‘Krugman view’ that fiscal stimulus is required to address high unemployment. However, there is a need to think beyond current orthodoxy if monetary and fiscal policies are to be properly coordinated for this purpose in current circumstances. In the case of periphery countries, macroeconomic policies need to focus not only on reducing unemployment but should be more ambitious and aim to address both ‘high unemployment’ and ‘high debt’ simultaneously. This column recommends a macroeconomic policy combination that could achieve this objective. After punishing austerity, periphery economies need to be reflated: it is time to debate and to develop a new approach.

Each new day brings new statistical evidence illustrating the continuing economic malaise and the renewed downturn in periphery countries. Unemployment rates in those countries vary between 14% and 25%.  IMF analyses of fiscal multipliers suggest that the contraction in Europe will be deeper than earlier anticipated. Even so, it seems that austerity is to be continued.  It is becoming clearer, therefore, that current macroeconomic policy settings are inappropriate for the new era of high public debt burdens and high unemployment.

Krugman’s analysis

In a recently syndicated article, ‘Reducing Unemployment Way Back to Prosperity’ (2013), Paul Krugman convincingly argues that countries that have adopted austerity have continued to perform relatively poorly.  Roberto Tamborini (EconoMonitor, 2013) provides compelling statistical evidence in this regard.

These comparisons between Europe and the United States demonstrate that the current European macroeconomic strategy — agreed earlier by governments, the European Central Bank and the IMF — is misguided.  Rather than solving problems, current policies are contributing to a deepening downward momentum and to the maintenance of on-going debt burdens of periphery countries.  The naively conceived European ‘austerity’ experiment is proving to be a colossal mistake.

If the current economic downturn in periphery countries is not addressed urgently by major macroeconomic policy changes then the financial crisis will deepen and become more widespread.

Paul Krugman argues that; ‘It is time to put the deficit obsession aside and get back to dealing with the real problem — unacceptably high unemployment’.  Here, however, in respect of periphery countries,  there is potential for a further major blunder if policy makers are not very careful.  This is so because there are two main problems facing periphery countries — high debt and high unemployment — and they are both of such magnitude that they need to be solved simultaneously. Addressing the unemployment problem by bond financed fiscal stimulus would further exacerbate the ‘debt’ problem. That approach would represent a further colossal policy mistake.

As there is more than one policy objective and more than one policy instrument involved, periphery governments need to avoid a classical macroeconomic problem: ‘policy dissociation’.  Avoiding policy dissociation will ensure consistency, the avoidance of discordant policies, the rejection of policy combinations where different policy instruments are pulling policy targets in different directions, and the avoidance of situations where action with one policy instrument to correct problem A compounds problem B. Such discordant policies serve to deepen, rather than resolve, the underlying economic problems. For example, an attempt to resolve the problem of ‘high debt’ by forgetting about the unemployment problem, or the potential for either high inflation or deep deflation, would represent a major policy blunder.  So too would an attempt now to ‘lower unemployment’ by forgetting about the high debt problem and adopting bond financed fiscal stimulus.

Orthodoxy and policy principles

In a new book, ‘How to Solve the European Economic Crisis; Challenging orthodoxy and creating new policy paradigms‘ (available on Amazon), I identify a range of current policy orthodoxies that are failing to resolve the major economic problems confronting various nations.  These include the belief that monetisation of the budget deficit is evil and will lead to hyperinflation; the belief that more quantitative easing will provide economic stimulus; the belief that central banks should necessarily be ‘independent’; the belief that budget deficits per se increase public debt; the belief that real wages must necessarily be cut to reduce unemployment; and the belief that austerity and massive unemployment are necessary to reduce wages.

The book sets out 24 policy principles that could be used to guide future policy developments in Europe.  These principles include: the need to end attempts to solve debt problems by adding even more debt;  the need to achieve close coordination between all arms of macroeconomic policy, particularly monetary and fiscal policy; the need to avoid policy dissociation; the need to address ‘competitiveness’ problems by deploying prices, incomes, competition and labour market policies, rather than by relying on austerity; the need to reject uniform and  ‘one-size-fits-all’  policy strategies when divergences among countries are large and underlying problems differ; the need for debt forgiveness to avoid worst case scenarios, and the need to move beyond ‘defensive’ monetary policies that aim merely to buy more time.

The policy recommendation

The central policy proposal in the book involves the financing of on-going budget deficits not by creating even more public debt but by using new money now being channelled pointlessly into commercial bank reserve accounts.  Once fiscal stimulus is delivered in this way, sterilization could be used, if needed, to ensure there would be no adverse inflationary consequences.

The implication in the book is that policy authorities who called for large scale fiscal stimulus to address the global financial crisis failed to ask themselves a fundamental question: how were these deficits to be financed in a way that would not contribute to an explosion in public debt?  Furthermore, however, many of those same authorities a year or two later abandoned their support for large scale fiscal stimulus and agreed with ‘austerity’ policies.  Now the schizophrenia is deepening, as some authorities are calling on countries to avoid front loaded austerity.  What has happened to ‘coherency, consistency and continuity’?  Which of these strategies is appropriate to generate economic recovery?  It is not adequate to simply take a two-way, or a three-way, bet!

Under the plan proposed in the book, economic stimulus could be delivered to turn economies around: rising public debt could be stopped in its tracks. The German/northern taxpayers would receive immediate relief to their future tax burdens.

In his Cass Business School Lecture delivered on 6 February Lord Adair Turner has also expressed concern in relation to the UK and argues that we should cease treating overt money finance as a taboo subject.

No more quantitative easing

In relation to Japan and the United States in particular, it is argued — following the largest monetary expansion in modern history and record low interest rates — that further quantitative easing is unnecessary and likely to prove counter-productive.  Further quantitative easing aimed at lowering longer-term interest rates will distort the yield curve; interfere with risk reward profiles and resource allocation; lower the incomes and consumption of those dependent on interest receipts; cause temporary asset and share price price booms; encourage risk-taking; lower the home country exchange rate and raise exchange rates in other countries, destabilising financial markets and policy-making and creating ‘currency wars’; and, sow the seeds for a later destabilising financial crisis that will develop if monetary authorities are forced to sell securities to fight inflation or address the high risk building up on their balance sheets.

The book suggests that the authorities have failed to ask a very basic question: if there is a need to create new money to address declining activity and high unemployment, how is the new money best deployed to stimulate consumption demand and economic activity without raising public debt?

The book argues for much closer coordination between monetary and fiscal policies in the new circumstances of high public debt and high unemployment.  As all arms of macroeconomic policy need to be harnessed, it is appropriate that governments and Ministries of Finance (and not independent central banks) — that is, those charged with wide-ranging policy responsibilities — take the lead role in planning, coordinating and sequencing the strategic policy responses in a timely manner. The proposal applies whether or not periphery countries remain inside or leave the monetary union.


Krugman, Paul (2013), ‘Reducing unemployment way back to prosperity’, Canberra Times, 4 February.

Tamborini, Robero (2013), ‘Italian Austerity in the Polls’, EconoMonitor, February 4.

Turner, Adair (2013), ‘Debt, Money and Mephistopheles: How Do We Get Out Of This Mess’, Cass Business School Lecture, 6th February

Wood, Richard (2012), ‘How to Solve the European Economic Crisis: Challenging orthodoxy and creating new policy paradigms’, Amazon Book Site, December.

5 Responses to "Periphery Macroeconomics and Paul Krugman: Correct Diagnosis but his Policy Recommendation Does Not Go Far Enough"

  1. lucad10   February 6, 2013 at 6:10 pm

    What about addressing the problem of x-rate regimes ?

    Does China still deserve a x-rate regime which is not a 100% free floating one ?
    Is it fair that 1 euro is equal to 8+ renmimbi ?

  2. paul   February 8, 2013 at 2:29 am

    suppose one economy invests 20% of his BNP on 'food' as an economic stimulus. Another economy invests 20% of his BNP on isolation of his homes. Then in a secondround the first economy has 120% BNP debt and become fat. In the second economy has 115% debt and gaining each year 5% on his tradebalans on less dependency on energy… A third country invests in a new factory producing the insulation and energy techniques… The third country augments his BNP dwarfing his debts… and accumulating the added value in his economy.

    So wat is the best thing to do ? Not mere spending, but searching for the opportunities that create added value, dwarfs the debts, and minimizes energy imports

  3. NAIBER   February 11, 2013 at 9:54 am

    No need for 'sterilization', just set lending limits to the banks.

    Little bit of regulation, woulnd that make much more sense than pretend that money has run out in the whole economy and nobody can afford to spend more?

    Declining economy, millions of unemployed vs little bit of regulation? Is it a hard choise?

  4. james   February 12, 2013 at 9:51 am

    Ok lets get this straight Austerity does not feel good– that is because you are trying to get over a monetary drunk binge. Taking away the free booz always feels bad. So Krugman's big insight is that austerity feels bad and austerity – living within your means and paying your bills is not the responsible thing to do. What is responsible is to continue the binge. Free money got us into this mess and more free money will make us feel better. Yep needs a Nobel Prize to figure that one out.

  5. joseph glynn   February 13, 2013 at 5:07 pm

    It's good to see someone is thinking outside the box, free of the straight-jacket of economic group think.
    The 2007/8 crisis was a golden opportunity to unshackle our economies from the dictat of private bankers and to embark on a new more sustainable course. A global carbon tax, a land value tax and public interest banking are needed.

    Instead, our political leaders now restore the banks to rude good health and recreate conditions prior to the crash. The croneys never learn and why should they. It pays well!