The Smith/Klein/Kalecki Theory of Austerity

by Paul Krugman

Noah Smith recently offered an interesting take on the real reasons austerity garners so much support from elites, no matter how badly it fails in practice. Elites, he argues, see economic distress as an opportunity to push through “reforms” — which basically means changes they want, which may or may not actually serve the interest of promoting economic growth — and oppose any policies that might mitigate crisis without the need for these changes:

I conjecture that “austerians” are concerned that anti-recessionary macro policy will allow a country to “muddle through” a crisis without improving its institutions. In other words, they fear that a successful stimulus would be wasting a good crisis.

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If people really do think that the danger of stimulus is not that it might fail, but that it might succeed, they need to say so. Only then, I believe, can we have an optimal public discussion about costs and benefits.

As he notes, the day after he wrote that post, Steven Pearlstein of the Washington Post made exactly that argument for austerity.

What Smith didn’t note, somewhat surprisingly, is that his argument is very close to Naomi Klein’s Shock Doctrine, with its argument that elites systematically exploit disasters to push through neoliberal policies even if these policies are essentially irrelevant to the sources of disaster. I have to admit that I was predisposed to dislike Klein’s book when it came out, probably out of professional turf-defending and whatever — but her thesis really helps explain a lot about what’s going on in Europe in particular.

And the lineage goes back even further. Two and a half years ago Mike Konczal reminded us of a classic 1943 (!) essay by Michal Kalecki, who suggested that business interests hate Keynesian economics because they fear that it might work — and in so doing mean that politicians would no longer have to abase themselves before businessmen in the name of preserving confidence. This is pretty close to the argument that we must have austerity, because stimulus might remove the incentive for structural reform that, you guessed it, gives businesses the confidence they need before deigning to produce recovery.

And sure enough, in my inbox this morning I see a piece more or less deploring the early signs of success for Abenomics: Abenomics is working — but it had better not work too well. Because if it works, how will we get structural reform?

So one way to see the drive for austerity is as an application of a sort of reverse Hippocratic oath: “First, do nothing to mitigate harm”. For the people must suffer if neoliberal reforms are to prosper.

Cyprus - Treasure Island Trauma

Paul Krugman in The New York Times

A couple of years ago, the journalist Nicholas Shaxson published a fascinating, chilling book titled “Treasure Islands,” which explained how international tax havens — which are also, as the author pointed out, “secrecy jurisdictions” where many rules don’t apply — undermine economies around the world. Not only do they bleed revenues from cash-strapped governments and enable corruption; they distort the flow of capital, helping to feed ever-bigger financial crises.

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Fred R. Conrad/The New York Times

Paul Krugman

 

 

One question Mr. Shaxson didn’t get into much, however, is what happens when a secrecy jurisdiction itself goes bust. That’s the story of Cyprus right now. And whatever the outcome for Cyprus itself (hint: it’s not likely to be happy), the Cyprus mess shows just how unreformed the world banking system remains, almost five years after the global financial crisis began.

So, about Cyprus: You might wonder why anyone cares about a tiny nation with an economy not much biggerthan that of metropolitan Scranton, Pa. Cyprus is, however, a member of the euro zone, so events there could trigger contagion (for example, bank runs) in larger nations. And there’s something else: While the Cypriot economy may be tiny, it’s a surprisingly large financial player, with a banking sector four or five times as big as you might expect given the size of its economy.

Why are Cypriot banks so big? Because the country is a tax haven where corporations and wealthy foreigners stash their money. Officially, 37 percent of the deposits in Cypriot banks come from nonresidents; the true number, once you take into account wealthy expatriates and people who are only nominally resident in Cyprus, is surely much higher. Basically, Cyprus is a place where people, especially but not only Russians, hide their wealth from both the taxmen and the regulators. Whatever gloss you put on it, it’s basically about money-laundering.

And the truth is that much of the wealth never moved at all; it just became invisible. On paper, for example, Cyprus became a huge investor in Russia — much bigger than Germany, whose economy is hundreds of times larger. In reality, of course, this was just “roundtripping” by Russians using the island as a tax shelter.

Unfortunately for the Cypriots, enough real money came in to finance some seriously bad investments, as their banks bought Greek debt and lent into a vast real estate bubble. Sooner or later, things were bound to go wrong. And now they have.

Now what? There are some strong similarities between Cyprus now and Iceland (a similar-size economy) a few years back. Like Cyprus now, Iceland had a huge banking sector, swollen by foreign deposits, that was simply too big to bail out. Iceland’s response was essentially to let its banks go bust, wiping out those foreign investors, while protecting domestic depositors — and the results weren’t too bad. Indeed, Iceland, with a far lower unemployment rate than most of Europe, has weathered the crisis surprisingly well.

Unfortunately, Cyprus’s response to its crisis has been a hopeless muddle. In part, this reflects the fact that it no longer has its own currency, which makes it dependent on decision makers in Brussels and Berlin — decision makers who haven’t been willing to let banks openly fail.

But it also reflects Cyprus’s own reluctance to accept the end of its money-laundering business; its leaders are still trying to limit losses to foreign depositors in the vain hope that business as usual can resume, and they were so anxious to protect the big money that they tried to limit foreigners’ losses by expropriating small domestic depositors. As it turned out, however, ordinary Cypriots were outraged, the plan was rejected, and, at this point, nobody knows what will happen.

My guess is that, in the end, Cyprus will adopt something like the Icelandic solution, but unless it ends up being forced off the euro in the next few days — a real possibility — it may first waste a lot of time and money on half-measures, trying to avoid facing up to reality while running up huge debts to wealthier nations. We’ll see.

But step back for a minute and consider the incredible fact that tax havens like Cyprus, the Cayman Islands, and many more are still operating pretty much the same way that they did before the global financial crisis. Everyone has seen the damage that runaway bankers can inflict, yet much of the world’s financial business is still routed through jurisdictions that let bankers sidestep even the mild regulations we’ve put in place. Everyone is crying about budget deficits, yet corporations and the wealthy are still freely using tax havens to avoid paying taxes like the little people.

So don’t cry for Cyprus; cry for all of us, living in a world whose leaders seem determined not to learn from disaster.

Britain can’t afford to fall for the charms of the false economics Messiah Paul Krugman Superstar economist Paul Krugman wants us to change course, but his solutions are simplistic.

Jeremy Warner in the Telegraph

What does the future hold as Europe slides, ever more hopelessly, towards the abyss? As David Cameron has pointed out, there have been 18 EU summits since he became Prime Minister little more than two years ago, and none of them has produced anything remotely resembling a solution.

The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.

The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.

But fear not – salvation is at hand. Next week, there comes to these shores a Messiah, a prophet of great wisdom and understanding whose teachings promise to vanquish despair and “end this depression”. He is Prof Paul Krugman, a superstar polemicist who has been described by The Economist as “the most celebrated economist of his generation”. Actually, “celebrated” is not exactly the right word, for Krugman divides opinion like no other. To his followers, he’s a saint; to his detractors, he’s a false prophet with satanic intent.

I’ve been a little misleading here. He’s not really coming to Britain to save us, but rather to promote his latest book, End This Depression Now! Krugman is an economist with attitude, and he thinks Britain is in the midst of a “massive blunder” in economic policy. The UK is the very worst example of austerity economics, he believes, for unlike the poor beleaguered nations of the eurozone periphery, we’ve not had this misery forced on us by the ghastly euro, but have opted for it as an unnecessary penance for the sins of the boom. If only we could be persuaded to forsake “Osbornomics” and tread the path originally set out by our dearly beloved former leader, Gordon Brown – that of spending our way back to growth – then all would be well again.

Put like that, of course, it sounds ridiculous, but the fact that Krugman is a Nobel prize-winning economist gives Labour’s calls for a U-turn on the economy an intellectual credibility they would otherwise struggle to attain.

All the great economists – from Adam Smith to John Maynard Keynes – were as much moral philosophers as dispassionate analysts of events, and Krugman is no exception, preaching his message with all the passion of the religious zealot. He feels our pain and begs us to let him help. “The road out of depression and back to full employment is still wide open,” he insists. “We don’t have to suffer like this.”

Krugman may appear loud and radical, but he follows a fairly standard Keynesian text. By his own admission, the social cost of the present downturn doesn’t come anywhere close to the Great Depression of the interwar years, or not yet. None the less, there are parallels, and we already meet Keynes’s classic definition of a depression as a “chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse”.

In such circumstances, monetary policy can help, but only up to a point. In a depression, even those with the balance sheet strength to spend and invest won’t do so, whatever the encouragement offered through ultra-low interest rates. It follows that governments should step into the breach and do the job instead, as a kind of spender of last resort. They can worry about the accumulated debt later, once output has picked up again.

To Krugman, it’s understandable that policymakers screwed up so monumentally in the Great Depression; they didn’t understand what was going on and there was no template for the circumstances they found themselves in. To his mind, there is no excuse this time around; it’s textbook stuff, which is being wilfully ignored.

But haven’t we already tried borrowing to stimulate? And what did it deliver other than fiscal ruin, which in the eurozone periphery is so serious that markets have stopped lending altogether? Krugman has an answer for these questions, too. It’s not the policy that was wrong, merely that the stimulus wasn’t big and sustained enough. As for the eurozone, again, it wasn’t the policy, but the euro. Countries with their own currencies and central banks won’t run into this kind of problem. In extremis, they can always print the money.

Easy peasy, then. What’s not to like? Well, I’m sorry, but I just don’t buy it. It may or may not be possible for a vast, largely internalised economy such as the US, with its reserve currency status, to run double-digit deficits into the indefinite future without adverse consequences, but for the UK it is a much more questionable policy.

True, Britain has lived with much higher debts relative to GDP in the past, but this has nearly always coincided with major wars. With demilitarisation, much of this borrowing to spend falls away and domestic consumption comes roaring back. No such get-out-of-jail-free card exists this time around. Further, the demographic is completely different from that of the post-war baby boom generation, where growth and therefore debt erosion were more or less guaranteed. Today, the unfunded liabilities of an ageing population stretch menacingly into the long-term future.

As it is, government spending in the UK is already approaching 50 per cent of GDP. Just how high does Prof Krugman propose it should go? It’s all very well to say “jobs first” and worry about the deficit later, but once government spending becomes entrenched, it’s very difficult to get rid of it. Even Reagan and Thatcher struggled to make significant inroads.

In any case, the picture Krugman presents of wrong-headed British austerity is a caricature of the reality, though one admittedly encouraged by the Coalition’s rhetoric. Yesterday’s revised GDP figures, showing that the country is even deeper in recession than we thought, would appear to support the mocking tone in which Krugman condemns the idea of “expansionary austerity”. But where is this austerity? In fact, one of the few positive contributors to output in the last quarter was government spending, which grew by 1.6 per cent. Krugman seems to have forgotten the automatic stabilisers, which because of our welfare state are considerably bigger than in the US. In America, much current UK spending would count as a discretionary fiscal stimulus of the sort End This Depression Now! advocates.

As Raghuram Rajan, a former IMF chief economist, has argued, today’s troubles are not simply the result of inadequate demand, but of major changes in the world economy brought about by globalisation. The old monopoly of knowledge and expertise once enjoyed by advanced economies has been swept away. For decades, we compensated for the jobs and income lost to technology and cheaper foreign competition with unaffordable government spending and easy credit. Much of the growth enjoyed in these pre-crisis years was simply unsustainable.

Paul Krugman’s message is seductive, but it’s also unrealistic. If only the solutions to our plight were as simple as he thinks.