Austerity and the Euro in Two Graphs: A Reply to Paul Krugman
Paul Krugman started the New Year yesterday with a zingy little post in his New York Times blog titled “The State of the Euro in One Graph”. Here is the graph . . .
. . . and here is the text that accompanies it:
What you see here is that borrowing costs for the troubled euro countries have dropped a lot. But it’s not because austerity policies have brought their debt under control — debt ratios are still rising, in large part because of shrinking economies and deflation. Instead, there has been a dramatic flattening of the relationship between debt and interest rates.
Oops. I see two problems here.
- If “shrinking economies” are distorting fiscal policy indicators that are stated in relation to current GDP (and they are), shouldn’t his graph measure the debt ratio relative to potential GDP, not current GDP?
- Since when is the debt ratio the proper measure of austerity policy? Austerity, which we used to call fiscal consolidation, means reduction of the deficit, not the debt. The debt ratio is too strongly influenced not only by the state of the economy, but by past fiscal history, to be a good measure of year-to-year changes in the policy stance. The chart is further muddled because debt dynamics are strongly influence by interest rates, the variable on the vertical axis.
Let me suggest an alternative graph that better illustrates the relationship between changes in fiscal policy and changes in interest rates. This version has the 10-year government bond rate on the vertical axis (I think that is what Krugman uses, although he doesn’t say so) and the underlying primary balance (UPB) on the horizontal axis. The latter is an indicator favored by the OECD that is similar to what we more commonly call the primary structural balance (PSB). Like the PSB, it is the surplus or deficit of the government budget, adjusted for both interest payments on the debt and the state of the business cycle. The UPB differs from the PSB in that it also corrects for one-off budget measures like tax amnesties and privatizations, factors that are important for some of the European crisis countries.
My alternative version of the chart bears a superficial resemblance to Krugman’s original, in that the arrows all point down and to the right. In fact, though, the message it suggests is exactly the opposite of the concusion Krugman wants us to reach. Krugman invites us to interpret his graph as showing that austerity is not the cause of falling interest rates, whereas the alternative version suggests that austerity is helping to bring interest rates down.
Who is right? Well, we all know that correlation is not causation, so neither graph really proves anything. The most we can say about any such graph is whether it is consistent or inconsistent with some hypothesis about the economy. Anyone who understands the basic economics of fiscal policy can recognize that a tendency for the current debt ratio to rise while interest rates are decreasing is not inconsistent with the hypothesis that austerity is the cause of the decrease in rates. A tendency for interest rates to fall as the underlying balance moves toward surplus is consistent with the hypothesis that austerity is at least among the factors bring rates down.
As regular readers of this blog will know, I am no big fan of fiscal austerity during a slump. Such policies are procyclical. The time to fix the fiscal roof is when the cyclical sun is shining. Premature fiscal consolidation has very likely slowed recoveries from the global crisis in both Europe and the United States. Also, I would not dispute that the “Draghi effect,” as Krugman calls it, is a contributing factor in bringing euro interest rates down. The European Central Bank Chairman’s pledge to use all available tools of monetary policy to save the euro undoubtedly has had some effect on rates. Still, it does seem plausible that, when deciding how much to pay for euro bonds, investors have taken into account the huge swings toward surplus in the underlying balances of the crisis countries.
Paul Krugman, I think, knows all this. Although it is only January 2, may I nominate his graph for the most disingenuous of the year?
16 Responses to “Austerity and the Euro in Two Graphs: A Reply to Paul Krugman”
Is it possible that Dolan is seeking countercyclical fiscal policy, but Krugman is not? To stabilize the cycle, fiscal policy needs to be less expansionary (more austere?) when the economy is growing faster and more expansionary when the economy is growing slower or contracting. Isn't Krugman's preferred policy greater fiscal expansion whether the economy is growing faster or slower?
In fairness, I think Krugman endorses countercyclical fiscal policy in principle, although it has been a long time since I have seen him write anything about policy at the top of the cycle. One of the sources of procyclical bias in fiscal policy is setting an unrealistic target for what "full employment" is. For example, keeping vigorous expansion going until unemployment reached 4 percent would very likely be destabilizing for the US economy. Krugman is perhaps not immune to that kind of bias.
I wonder whether Paul Krugman is simply ignorant of the mistakes he made with this chart (and many others before) or whether he is deliberately trying to manipulate public opinion. Either way it does not reflect well on the good professor and noble laureate.
I´m no economist so I risk saying stupid things, but leaving in one of those ´sponsored´ countries still feel half entitled to comment on this.
The German/IMF program intend is to drive the ´sponsored´ countries to an economic position where those same countries have the ability to pay their debts in full.
I hope all could agree with this ultimate goal, as otherwise not much in the chosen path would make much sense.
As such any index to measure the said program that would leave out either 1) the ´sponsored´ countries ability to pay back their debt interests and 2) the long term sustainability of the achieved fiscal consolidation looks, in my non educated view, as grossly misleading.
From what I understood UPB fails to capture 1) by definition & any could argue that the achieved fiscal consolidation is not really sustainable on the long term, as for the most part it is not being achieved through competitiveness grow but by shutting down people buying power/will by forcing many into poverty.
In this sense, except if the bond people are really stupid, Krugman graph and following interpretation looks, in this side of the keyboard, as a much more honest explanation on what is justifying the fall of the interest rates – a central bank threat to act as a… central bank. For the unhappiness of some, goes without saying. Crazy world!
I just don´t really share Krugman enthusiasm for the Euro future.
Your concern about long-term sustainability of fiscal policy is widely shared. One rule of thumb is that the PSB (that is, the UPB without taking one-offs into account) should be equal to or greater than the real interest rate on government debt minus the growth of real income. Very broadly speaking, most studies consider that a small positive value for the PSB would be adequate to achieve sustainability in that sense. Italy and Greece appear to have reached this level of PSB and Portugal and Ireland are close to it, according to OECD data for 2013. (Read more about this rule of thumb in the series of earlier posts linked at the start of this one: http://www.economonitor.com/dolanecon/2013/01/28/…
The real question, though, is how fast the PSB or UPB should move toward surplus when the economy is still in recession. Under some circumstances, critics say, delaying austerity measures until later into a recovery could improve the ability of a country to repay its debts.
Thanks for the link, i went through it and guess grasp most of the basic concepts. But still fail to understand your comment that Portugal is close to a sustainable debt.
Country debt is ~130% with an average interest of something around 4% (no specific reference, just numbers found in the media). A quick and simplistic calculus drive ~5% of the internal product shall be used just to service debt, a surplus I´ve never heard of.
In any case hope you´re right.
Ed, as I told you on twitter, I think that Krugman's point is right. This is because at the moment when borrowing costs rose, the Troika identified the high public debt levels of those countries as the underlying cause of this rise (and not high fiscal deficits). Because of that, the aim of fiscal austerity was to bring down the debt ratio, which was demonstrated that that could not be done by applying fiscal austerity (as you also point out).
Before the crisis began, most of these countries had small fiscal deficits, or even superavits. They incurred into deficits because of countercyclical policies and rescues to the private sector (and even then borrowing costs did not rose).
In my opinion these borrowing costs went up because of a panic effect generated by the affaire of greek statistics. Public debt or fiscal deficits had nothing to do with it. And then they went down when this panic effect dissapeared (greece arrengement with the troika and Draghi´s speech).
My lecture of Krugman's point is that all the pain and suffering generated by fiscal austerity could have been avoided if the BCE had acted quickly calming the markets by establishing itself as a lender of last resort (and this accompanied by a centralization of fiscal policy and fiscal debt management).
Juan Manuel Telechea http://estructuradesequilibrada.blogspot.com.ar/
Thank you for amplifying. For all my love of Twitter as a means for calling attention to interesting topics, I find it useless for debate. Here, I have already burned up more than a Tweet and I haven't even addressed your very important points yet.
(1) Yes, there is something to what you say, that the Troika identified the debt ratio as the problem. There was a lot of chatter about the 90 percent debt limit, and all that, some of which is now seen by many economists and policymakers as misguided. However, I think the underlying purpose of the Troika's concern, and that of investors, was whether fiscal policy as a whole was sustainable. Even though the debt ratio was given exaggerated status as an indicator of sustainability, there were a limited number of tools available to move toward sustainability, to be used singly or in combination: Adjust the debt ratio directly through default or restructuring; privatization (that is, reduce financial liabilities by selling real assets); or "austerity," that is, reduce the structural deficit through tax increases and spending cuts. No one ever claimed that fiscal policy could be made sustainable without the austerity element. Even when there was exaggerated focus on the current debt ratio as an indicator of sustainability (and it is a bad one), austerity was always seen as an essential tool. Until it was deployed, neither the Troika nor investors would be wiling to believe that the debt ratio could be stabilized. I offer the UPB (or PSB) simply as the appropriate indicator of whether countries were in fact deploying this tool.
(2) You say "Before the crisis began, most of these countries had small fiscal deficits." That is true if you look at current deficits, but saying that only exposes the naivite of the Maastricht fiscal rules in using the current deficit as an indicator of healthy fiscal policy. The real problem is that all of the future crisis countries, with the exception of Spain, were pursuing procyclical fiscal policies, that is, running large structural deficits in the mid-2000s when GDP was running above potential. Greece, Ireland, and Slovenia were also running large underlying primary deficits. Italy had a small primary surplus, but not large enough to assure "mathematical sustainability" of fiscal policy, given its large debt ratio. The big failure of EZ fiscal policy before the crisis was a failure to realize the unsustainability and procyclicality of fiscal policies during the boom of the mid-2000s.
(3) I do agree there was a big psychological element to the crisis. Investors panicked and policymakers could have reduced the panic by reacting more quickly. That is the second fault of EZ policy: Quick reaction is structurally impossible. That is why it was so bad that they ignored structural indicators in earlier years. If you can't react quickly in a crisis, it is better not to let one develop.
Let me close by making it clear where I agree and disagree with Prof. Krugman: I agree on the important point: "Austerity," meaning sharp forcing of the UPB toward surplus in countries with large negative output gaps, is bad policy. It compounded the procyclicality that began when countries allowed their structural deficits to swell during the preceding boom. Where I disagree with Krugman is in whether the trajectory of the current deficit ratio is a good indicator of the stance of fiscal policy. It is not. Therefore, a chart featuring the trajectory of the current deficit ratio should not be offered as evidence that "austerity does not work." Austerity in fact does "work" in the sense that it has helped bring down interest rates. It just doesn't "work" in the sense of promoting stability and prosperity in the crisis countries.
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[…] EconoMonitor : Ed Dolan's Econ Blog – Austerity and the Euro in Two Graphs: A Reply to Pa… Ed Dolan goes after Paul Krugman. As regular readers of this blog will know, I am no big fan of fiscal austerity during a slump. Such policies are procyclical. The time to fix the fiscal roof is when the cyclical sun is shining. Premature fiscal consolidation has very likely slowed recoveries from the global crisis in both Europe and the United States. Also, I would not dispute that the "Draghi effect," as Krugman calls it, is a contributing factor in bringing euro interest rates down. The European Central Bank Chairman's pledge to use all available tools of monetary policy to save the euro undoubtedly has had some effect on rates. Still, it does seem plausible that, when deciding how much to pay for euro bonds, investors have taken into account the huge swings toward surplus in the underlying balances of the crisis countries. […]