by Titus
Sun Jun 27th, 2010 at 05:04:12 AM EST
With the European drive towards austerity gaining momentum, Krugman and many others are writing the Continent off as heading towards a lost decade (or worse) and of imperilling the world economy. That may be true. However, I believe austerity may work.
I should note, however, is that while austerity may work, there is no guarantee it will. I do not assume that our esteemed leaders know why it might work - quite the contrary, as a matter of fact. And if austerity does work, it certainly won't work for the stated reasons. In fact, if it does work it'll do so on purely keynesian principles, as an accidental result of our leaders' bumbling. And even if it works the periphery has little to look forward to.
front-paged by afew
1. Europe and the World
With employment less than full ... all the debunked mercantilistic arguments [about job-stealing] turn out to be valid. - Paul Samuelson (Quote courtesy of Krugman's blog)
From the point of view of the world economy, European austerity is pure madness. The world economy is depressed: It is operating at less than full employment due to a failure of demand. In this regard, governmental austerity, which further lowers demand, is insane, since it only worsens the slump, and leads to a reduction in tax revenue. The same would be true in a completely closed economy.
However, let us assume we aren't concerned about the global economy. Let's assume instead that as long as our (European/national) economy is doing well, the world economy can go hang itself for all we care.
In this case, the logic of austerity changes. Yes, austerity does further depress the world economy. However, the picture for the economy that practises austerity is different. As Krugman noted:
We do have a framework for thinking about this issue: the Mundell-Fleming model. And according to that model (does anyone still learn this stuff?), fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a whole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country -- partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world. (Rudi Dornbusch's 1976 Brookings Paper went through all this.)
http://krugman.blogs.nytimes.com/2010/06/09/the-global-transmission-of-european-austerity/
Essentially, as Krugman implies elsewhere (if I've got it correctly), this is a free-rider issue: An austere state gains the full benefit of the savings but exports part of the cost. This, of course, presents a nasty dilemma to the rest of the world, since to dig their own and the world economy out of the hole they have to increase deficit spending more than they would without the free-rider issue. So, the austere state can benefit from others' efforts to revive the economy.
Of course, Krugman is also right in wondering where the demand is going to come from. A charitable interpretation of European austerity would be that the global recession is lopsided: While the developed world is in a recession, the developing world largely is not (even though it was necessary for it to inroduce stimulus programmes of its own). For example, the Indian economy grew by 9.4% in 2007, by 7.3% in 2008, and still managed to grow by 5.4% in 2009. For 2010, the projected growth rate (in part because of a $100 billion stimulus package) is 7.2% (source: http://www.economywatch.com/indianeconomy/indian-economy-overview.html).
China, on the other hand, engages in a beggar-thy neighbour strategy, but could still be a good source of demand, particularly if it's pressured, as the US is doing, to unpeg the renminbi. Even if it doesn't, the euro's fall against the dollar should make European exports more competitive.
Thus, one could argue that the euro's fall in value because of austerity will make European products, especially advanced ones, more competitive and that demand from developing world could help Europe recover even as it deepens the global slump, because developing countries need advanced goods (read: German machinery).
However, as it is, both China and Europe are currently counting on massive US deficit spending. Krugman said, as per the WSJ:
Krugman also told Handelsblatt he wouldn't rule out sanctions against Germany if it continued to rely on its export-driven model. "If the euro falls to parity with the dollar, the Europeans are going to be surprised by the demands that will come out of the U.S. Congress, and I would support that," he said.
Well, I would like to see that. I really would. The Republican superminority is clamouring for austerity and thinks free trade is the solution to all woes. A large chunk of the Democratic Party also favours reducing the deficit. And now, suddenly, all these luminaries who, together with conservative economists have been advocating austerity, are going to vote in sanctions against the EU because it practises what they preach? After months of pro-austerity propaganda? If you can sell that to the general public at this point, you can sell them anything. If the US is going to pressure a free-rider, I believe it's going to be China, because (i) it's easier to condemn currency manipulation than austerity, and (ii) an authoritarian Asian regime makes for a better Other to blame than European democracies.
On the other hand, I very much doubt the United States is going to try to reduce its deficit. Elections are coming up, and voters are worried about the economy. That means that politicians have to deliver. Or at least throw voters a bone or two. Ideally, cooler heads will prevail and the US will pass another stimulus package, either now or after the November elections, if the Democrats (the reasonably sane party) win.
Besides, with the Bush tax cuts reducing revenue, you probably can't cut the US deficit without (i) getting out of Afghanistan (not going to happen), (ii) cutting Social Security or Medicare and Medicaid (political suicide) or (iii) raising taxes (remote possibility, especially in a recession). And the US has no reason to. Interest rates are at historic lows, which make it attractive to borrow and spend the money on stimulus, even with free-riders.
2. Centre and Periphery
I said that, under these conditions, austerity might help the European economy recover.
That's not quite true.
Remember, the PIIGS (or, more generally, the European periphery) are in a bad way because of capital imbalances, which, in the absence of their own currencies with a floating exchange rate (see Latvia's refusal to devalue which has resulted in a true depression, amid praise from the EU, and Latvia is being proffered as an example to emulate!) created an upward pressure on prices and wages, making them uncompetitive against the European north, notably Germany.
Austerity, even if it works, will not solve that problem. At worst, the cycle will repeat itself. At best, banks will use the capital influx to repair their balance sheets, with peripheral governments being kept on life support through years of deflation with European "aid" (loans, really). So, we on the periphery (I'm Slovene) have little to look forward to, even if by some miracle this works.
But I think we cannot really look forward to a better policy. It seems the North - and Germany in particular - realises that the EU is in essence France and Germany. The European project wanted to intertwine their economies so closely that war between them would become impossible. France and Germany are the centre of the EU. We others are all expendable. If Slovenia leaves the eurozone or even the EU, no one will notice. If Greece and Portugal leave, no one will care. Even if Spain or Britain leaves, the EU will survive. If France or Germany leaves, it is dead.
To top it all off, leaving the eurozone is the worse option unless a country faces a collapse of its financial system anyway, since that's what reintroducing your own currency with the intent to devalue would do.
In short, the best we peripherals have to hope for is that structural imbalances within the eurozone will be addressed when the northern economies recover.
And it is unlikely austerity will produce a recovery even for the North (although, rather immorally, as a European I dearly hope it will), because, well, I have news for Frau Merkel and her Smurfs: If you're pursuing a beggar-your-neighbour policy, you do not want others to follow suit. Stop peddling austerity at the G20, for the love of God! And if Weber becomes the new head of the ECB don't let him raise interest rates. Tie him up, threaten him, I don't care. Don't let him raise interest rates. The euro needs to stay low.
Sigh.
I would like our leaders to pursue, just once, a policy that (i) has a more than small chance of working, and (ii) does not involve screwing anyone over. Is that too much to ask? And I really detest that a small, despicable part of me is hoping that a beggar-your-neighbour strategy works, since it seems to be the only strategy that's forthcoming. Call it rational self-interest. I call it a failure of my ethics.
And people are still voting conservative. I suppose that, in a democracy with a propostional voting system, we all get governments we deserve and not those we need. Oh, well. Learning curve.
A final note: I usually post on Daily Kos as Dauphin and, while this is my first diary on eurotrib, my record can be seen there.
