PAUL KRUGMAN, the Nobel Prize winning economist, was in top thundering form in his comments on the recent meeting of G-20 finance ministers, which – apparently prompted by the new coalition government in the UK - produced a noticeable change in political rhetoric by welcoming the plans by several countries to start tackling their hefty budget deficits.
“It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US” says Krugman. Bowing to demands from the financial markets for fiscal austerity, in his view, is “utter folly posing as wisdom”.
“Don’t we need to worry about government debt?” he goes on. “Yes — but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt”. The right thing would be to wait until after the economy is strong enough to allow monetary policy to offset fiscal austerity. “But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound”.
The intellectual credentials of Prof Krugman are scarcely in question. But is he right to warn that even starting to tackle the fiscal imbalances today dooms us to another recession, or even depression? Without getting into a futile doctrinal debate between followers of Keynes and the Austrian school of economists, the alternative view, much more popular in the circles which I frequent, is that tackling debt with yet more debt is a far surer way to long term ruin. Postponing the evil day, after all, was at the heart of the Federal Reserve’s failings in the later years of Alan Greenspan’s tenure and helped to land us where we are today.
Not even to begin laying the ground for reductions in public spending today, let alone to confront the huge unfunded liabilities that lie beyond budget planning horizons, makes little sense. On past form it will take years for any cuts announced today to be fully implemented, if indeed they can be achieved at all. Just as 364 economists turned out to be wrong when they denounced Sir Geoffrey Howe’s infamous 1981 UK budget, it is not axiomatic to me that Prof Krugman and co are right this time round.
In any event it is surely debatable to blame the imminence of spending cuts mainly on pressure from the financial markets. It is not, after all, as if the “bond market vigilantes” have been much in evidence recently. Long term bond yields have been falling, not rising – foolishly, history may yet judge. Pointing out the inconvenient fact that Greece and other countries have unsustainable fiscal problems is meanwhile hardly an insight confined to a few hedge fund managers.
What really seems to affront the liberal academic mind is the idea that financial markets – irrational, greedy and capricious as they indubitably can be at times – should be seen to be driving public policy in any way. Unfortunately, a good deal of the argument about fiscal consolidation is about the timing of economic recovery, the appetite for risk in the private sector and the second and third order effects of fiscal tightening. This kind of judgment, in my experience, has never been the forte of economists, whatever their school.
Unsurprisingly perhaps, I take more comfort from Paul Volcker, who as a former Chairman of the Federal Reserve has a gold-plated track record in dealing with the consequences of past financial excess (and was rightly lauded by Prof Krugman, among others, for that achievement). In an excellent recent article in the New York Review of Books, after discussing his plans for banking reform, Mr Volcker observes: “The critical policy issues we face go way beyond the technicalities of law and regulation of financial markets”.
“If we need any further illustration of the potential threats to our own economy from uncontrolled borrowing, we have only to look to the struggle to maintain the common European currency, to rebalance the European economy, and to sustain the political cohesion of Europe. Amounts approaching a trillion dollars have been marshaled from national and international resources to deal with those challenges. Financing can buy time, but not indefinite time. The underlying hard fiscal and economic adjustments are necessary”.
That sentiment is surely unquestionable. It is only recently however that political rhetoric across the indebted developed world is starting to match up to the scale of the challenge; and even then, it has to be said, the degree of realism that is on public display is often all too closely tied to the imminence of elections. President Obama’s intemperate attack on BP for its failings in the Gulf of Mexico shows that the syndrome is as true in Washington as it is in London, Frankfurt and Athens.
“As we look to that European experience” says Volcker “let’s consider our own situation. We are not a small country highly vulnerable to speculative attack. In an uncertain world, our currency and credit are well established. But there are serious questions, most immediately about the sustainability of our commitment to growing entitlement programs. Looking only a little further ahead, there are even larger questions of critical importance for those of less advanced age than I. The need to achieve a consensus for effective action against global warming, for energy independence, and for protecting the environment is not going to go away. Are we really prepared to meet those problems, and the related fiscal implications? If not, today’s concerns may soon become tomorrow’s existential crises”.
Mr Volcker also draws on a recent visit to Ireland to justify his view that optimism is not entirely out of place in this critical environment for policymakers. “It’s a small country, with few resources and, to put it mildly, a troubled history. In the last twenty years, it took a great leap forward, escaping from its economic lethargy and its internal conflicts. Responding to the potential of free and open markets and the stable European currency, standards of living have bounded higher, close to the general European level. Instead of emigration, there has been an influx of workers from abroad”.
“But now Ireland has been caught up in its own speculative excesses and financial deficits, culminating in a sharp economic decline. There is a lot of grumbling, about banks in particular. But I came away with another impression. The people I spoke to had an understanding that the boom had gotten out of hand. There seems to me a determination to do something about the situation, reflected not just in the words of the political leaders but in support for action among the public. And there is a sense of what is at stake, that the gains they made in recent years have been placed in jeopardy. The urgent need to get back on a sustainable budgetary and economic track is well understood”.
Not so, of course, in the United States. “Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large”.
There is no doubt that the hand of history is sitting heavily on the shoulders of the current generation of political leaders. They have critical judgments to make, and insufficient evidence to be sure that their decisions will turn out right. Mistakes are inevitable. The markets certainly have no monopoly on wisdom either – just look at their apparent readiness to lump in Hungary, a paragon of virtue in fiscal terms, with Greece. But the time for procrastination, as Mr Volcker is right to observe, is passing.
