The euro area’s push to revive confidence in its economy and financial markets by attacking budget deficits will be challenged at the ballot boxes of France and Greece on May 6 as the region’s economy skids toward its second recession in three years and unemployment nears 11 percent.
Leading demands for a revised strategy, French Socialist Francois Hollande, a reader of Krugman, tops President Nicolas Sarkozy in the polls with the warning that putting debt-cutting over expansion is “bringing desperation to people.” Elsewhere, Greeks are turning to anti-austerity parties, recession-wracked Spain and Italy are relaxing deficit targets, the Dutch government is splintering and European Central Bank President Mario Draghi is calling for a “growth compact.”
The U.K., which the International Monetary Fund reckons accounts for a third of the budget cuts in the 10 largest European Union countries, is already back in recession.
“You can’t do deficit reduction without the people” understanding and endorsing it, said Paul Martin, who as Canada’s finance minister through most of the 1990s turned a C$36 billion ($36 billion) shortfall into a surplus in three years. “Deficit reduction has to be balanced with growth and it’s pretty clear Europe (BEBANKS) has lost that balance.”
The debate has split policy makers, investors and academics alike as Europe pursued a cocktail of tax increases and spending cuts to beat a sovereign debt crisis that raged from Greece through Ireland and Portugal to the very heart of the single currency bloc.
In a camp that boasts fellow Nobel winner Joseph Stiglitz and former U.S. Treasury Secretary Lawrence Summers, Krugman’s voice has been loudest in warning that deploying austerity in a slump is self-defeating as it deepens the economic pain and can generate even higher debt. For pulpits, the 59-year-old Princeton University professor has a regular New York Times op- ed and blog. A book, “End This Depression Now!” was published this week and is already among the bestsellers on Amazon.com Inc.’s U.S. website.
‘Not a Whim’
“Francois Hollande has read Krugman,” Michel Sapin, one of Hollande’s economic advisers, said in an interview. “His writings show that Hollande’s proposals are not a whim and that this idea that growth is key is spreading.”
To Krugman, advocates of fiscal retrenchment such as German Chancellor Angela Merkel are ideological “austerians” who by misunderstanding the ills they’re trying to cure risk “Europe’s economic suicide.” He calculates that paring government spending by one euro ($1.32) generates only about 40 cents in reduced debt in the short-run and 1.25 euros in lost production.
“Aggressive fiscal austerity is self-defeating if you can’t grow,” said Andrew Balls, the London-based head of European portfolio management at Pacific Investment Management Co. (PTTRX), which oversees the world’s largest bond fund. “Krugman is a highly respected economist with a prominent platform who provides a very clear explanation of that view.”
Kevin O’Rourke, who teaches at the University of Oxford, calls Krugman a “genius” who is applying the “very simple” lessons of economics that were patronised as not technical enough by those who argued austerity wouldn’t derail growth.
“He has become the spokesman for all of us who believe that our time in undergraduate lecture halls was not wasted,” said O’Rourke, whose research Krugman has praised on his blog.
Not all buy it, including Germany’s Merkel, who pushed for a fiscal pact to ensure better discipline in the future and which 25 of the European Union’s 27 governments signed up to.
The skeptics argue Europe’s overly-indebted nations helped trigger the financial crisis and now will only attract investors and restore competitiveness once they have put their fiscal houses in order. Spain now pays almost 6 percent to borrow for 10 years, up from about 4 percent in 2009. Germany pays about 1.6 percent.
Draghi delivered no new monetary or liquidity stimulus after chairing a meeting of the policy-setting Governing Council in Barcelona today. The central bank left its benchmark interest rate at 1 percent.
“We can only win back confidence if we bring down excessive deficits and boost competitiveness,” Bundesbank President Jens Weidmann said April 23.
Columbia University economists Jeffrey Sachs and Edmund Phelps both reject Krugman’s view as a “crude” form of the pump priming proposals of John Maynard Keynes, the 20th century British economist. Federal Reserve Chairman Ben S. Bernanke last week dismissed Krugman’s call for the U.S. central bank to allow much faster inflation as “reckless.”
“I can’t stand this rubbish anymore,” said Norbert Walter, the former chief economist of Deutsche Bank AG who now runs his own consultancy. “If you are in a cul-de-sac the only way out is to go backward. Countries clearly living beyond their means must reverse.”
That’s the prescription of Merkel, who holds Europe’s purse strings. She backs austerity abroad in keeping with Germany’s historical preference for prudence, which dates back to the aftermath of overspending and hyperinflation in the 1920s.
“We’re not saying that saving solves all problems,” Merkel told a conference in Berlin on April 24. Still, “you can’t spend more than you take in. You can’t live your whole life this way. Everybody knows this.”
Krugman, who won the Nobel Prize in 2008 for his research on trade, argues the birth of the euro in 1999 led to a boom in money flowing into peripheral nations like Spain and Portugal as investors bet their debt was now as safe as Germany’s. Nations prospered with property often leading the way.
When the lending dried up amid the global credit crunch, the economic-tailspin and need to rescue banks propelled budgets and current accounts into the red. That shows to Krugman that, with the exception of Greece, the causes of Europe’s woes are private debts rather than fiscal irresponsibility.
Spain’s government, for example, ran a debt of 36 percent of gross domestic product in 2007 and Ireland’s was 25 percent. By comparison, Germany’s was 65 percent at the time. While Italy’s debt was 103 percent of GDP in 2007 its budget deficit was 1.6 percent and Ireland’s account was in balance. Take Greece, Ireland, Italy, Portugal and Spain as a group and its debt was declining into 2007, Krugman estimates.
That suggests public budget cuts are only intensifying the pain caused by a reduction of private investment and spending, according to Krugman. Deprived of their own currency or central bank to help lessen the pain through devaluation or printing money, countries are left trying to deflate their economies to regain competitiveness.
That leaves the likes of Spain now needing outside help, he says. In his view, the ECB could cut interest rates to encourage inflation and stand by to purchase more government bonds. Healthier nations with stronger budgets and trade positions such as Germany should stimulate their economies to increase demand and relative prices.
Irritated by the “Hellenization” of the economic debate, Krugman wants America to introduce more stimulus at a time when the U.S. pays just 1.9 percent to borrow for a decade.
“They’ve had a firming up of their view that austerity in the face of a depressed economy is actually harmful,” Krugman told Bloomberg Television.
Krugman’s argument chimes with that of Summers, the former Treasury secretary, who says the idea of being able to cut your way to growth “is oxymoronic and there are days when you don’t even need the prefix” oxy.
Using IMF data, Summers calculates that when demand is weak and interest rates are about zero, a one percent reduction in the ratio of spending to GDP reduces economic growth by as much as 1.5 percent.
“This means austerity measures at the national level are likely to be counterproductive in terms of creditworthiness,” he wrote in the Financial Times this week. “Fiscal contraction reduces incomes, limiting the capacity to repay debts.”
Spanish Prime Minister Mariano Rajoy and his Italian counterpart Mario Monti now both say it will take longer to balance their budgets than previously anticipated. Monti is implementing 20 billion euros of fresh spending cuts and tax hikes, while Spain is making the deepest budget cuts in at least three decades.
While stopping short of advocating stimulus, Draghi wants European countries to encourage greater structural changes, trading links, labor flexibility and competitiveness in ways that will lure private investment. Governments may add an annex to their budget pact listing ways countries can boost expansion.
“We have to put growth back at the center of the agenda without any contradiction with the need to continue, persevere in fiscal consolidation,” Draghi said today.
Hollande wants to go even further and advocates fostering growth by spending existing European funds and new revenue sources that would be generated from measures such as eurobonds and financial-transaction taxes.
While Germany is willing to strengthen the European Investment Bank to help it provide more support, Merkel is against broader spending, especially given the euro area’s aggregate government debt reached 8.2 trillion euros last year, the highest in the currency’s history.
The IMF projects Spain’s deficit to reach 6 percent of GDP this year and Italy’s debt to top 123 percent of GDP, both double the limits of the euro-area rules.
The German chancellor says such imbalances need correcting and that any talk of a growth compact should be limited to measures needing “political courage and creativity rather than billions of euros.”
Outside the euro, even as the U.K. economy suffers its first double-dip recession since the 1970s, Prime Minister David Cameron’s government is pushing ahead with the largest budget cuts since World War II, pointing to Greece as a reason. It would be “absolute folly” to change course and risk higher interest rates, Cameron said last week.
Nobel laureate Phelps said in an interview that he finds Krugman’s analysis “somewhat blinkered and shallow” because easing austerity in Europe could lead to even weaker economies as investors impose higher borrowing costs. Spain’s 10-year bond yield jumped about a percentage point after the government revised its deficit goal in early March.
“I’ll cut to the chase and say I don’t think his position is very well judged,” said Phelps. “I don’t think he’s paying enough attention to the fact that whatever the causes of the deficits are, countries are up against it.”
While Harvard University professor Kenneth Rogoff said he shares the point that faster inflation would be worthwhile, he said Krugman understates the pain debt can have on an economy in the longer-term.
In a paper published this week, Rogoff and co-authors Vincent and Carmen Reinhart find countries with debts exceeding 90 percent of the size of their economy historically have experienced subpar growth for more than two decades even if their interest rates remain low.
Krugman appears nonplussed. The alternative to action is Europe’s troubled economies end up correcting their imbalances in a glacial way and may eventually consider leaving the euro, something which will become more attractive as unemployment mounts. He already predicts Greece will jump or be pushed.
“That will concentrate minds,” he told Bloomberg Television. There are “echoes of the 1930s out there in Europe and this is scary.”
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