Welcome to “Paul Krugman Week” here on Making Sen$e. We’ll be devoting the next five days to excerpts from our extensive interview with him a few weeks ago at his home in Princeton, N.J., plus parts of a public interview at the First Parish Church in Harvard Square, Cambridge with NPR’s Tom Ashbrook, the remarkably knowledgeable host of “On Point.” We also will excerpt our interview with economist Robin Wells, Krugman’s partner in life and textbook writing.
In our first installment, Krugman discusses European austerity, and makes the point that no country that has its own currency is experiencing the problems the eurozone now faces. Below, a rebuttal of sorts from Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics.
Germany’s Concern Is Moral Hazard, Not Morality
The principal assertion made by professor Krugman concerning the German response to the euro area crisis is that it is all about “morality and debt is evil”. That, however, is a mischaracterization of the underlying reasons for the German unwillingness to immediately sanction large bailouts and focus on harsh austerity measures in the euro area. The real issue is moral hazard, not morality, and is rooted in the design flaws of the common currency, which grants member states (or at least did until the crisis) full sovereignty over issues such as their banking sector and most fiscal policy.
There is no doubt that in the ideal world the best response to a financial crisis is to deploy the “Powell Doctrine” of deploying overwhelming public sector financial force to quickly restore confidence among private investors. Such bailout actions, however, are inevitably politically premised on full ability of the “bailout giver” to dictate the actions of the “bailout recipient.” There was no political problem in, for instance, the United States, when Congress passed the TARP (Troubled Asset Relief Program), as Congress is fully sovereign and can dictate the actions of U.S. recipients. Similarly with the standard modus operandi of the IMF (International Monetary Fund), which only grants bailouts to governments that sign on to tough economic reform programs beforehand and essentially lose their national sovereignty in process.
In the euro area, however, where governments retain sovereignty over their banking systems and fiscal policies, “overwhelming crisis response force” — the immediate introduction of joint debt in the form of eurobonds, for example — is not a credible political option. German taxpayers have no direct say in the election of the Italian and Spanish governments and therefore their conduct of banking and fiscal policy. Eurobonds therefore suffer from inherent democratic deficits and would amount to “taxation without representation.”
Instead, Germany has focused on implementing the so-called Fiscal Compact, a new set of rules dictating the structural deficits that members of the euro can run, as well as other types of fiscal surveillance. This has led to significant fiscal austerity (including in core members like the Netherlands) and unquestionably deepened the regional economic slump in the short-term. However, it is not obvious that the large euro area periphery countries have a credible alternative. Would these countries be rewarded by investors for reversing austerity, and trying to reflate their still structurally unreformed economies instead? In all likelihood, no. The reality in both Spain and Italy — contrary to the United States — is that their labor market, and most of their product markets, remain sclerotic. Until structural reforms are implemented, additional stimulus spending would be wasted.
More broadly, though, the German focus on fiscal austerity should be understood as part of an longer-term process of European integration and the completion of economic and monetary union. As such, it should not be understood as “austerity only,” but “austerity first.” Without reestablishing fiscal consolidation and political integration (e.g. fiscal union), there will be no mutualization of sovereign debt (e.g. eurobonds). Austerity is best viewed as a necessary first step to limit the risks of moral hazard in the euro area.
One must further be on the guard for apples-and-oranges comparisons from the euro crisis. Professor Krugman’s comparison of Iceland and Greece is one. It seems probable that Greece made a terrible decision in joining the euro. However, while Iceland undoubtedly had the worst bankers (and the most-captured pre-2008 banking regulators), this small North Atlantic nation, with a population of just 317,000 and a GDP of $12 billion, by no means suffers from the deep structural economic problems that continue to plague Greece — and would still even if it could devalue. Iceland, apart from banking, is a generally well-managed economy with low levels of corruption and Greece is neither. Iceland ranks 13th in the world by Transparency international on corruption, while Greece is No. 80. And on competitiveness, the WEF ranks Iceland No. 30 in the world and Greece only No. 90. The introduction of the drachma would change none of these deep structural deficiencies and would in any case lead to a dramatic short-term collapse from the transition itself, much worse than the last three years of recession.
A further issue is what precise lessons to draw from Spain. The country had an enormous housing bubble and is currently dealing with the severe consequences of the subsequent bust. (Recall that unlike in the U.S., where Fannie Mae and Freddie Mac no hold most first mortgages, Spanish banks hold all of the country’s mortgage exposure on their balance sheets). It is therefore unsurprising that Spain is currently in a Nevada-like deep recession, amplified by archaic labor market regulation. There is no doubt that Spanish unit-labor costs deteriorated relative to Germany since the introduction of the euro area, but it is far from obvious that this was devastating to Spanish competitiveness. In fact, Spanish export growth since euro introduction in 1999 has been faster (up 126 percent from 1999 to 2011 — data at euro stat) than export powerhouse Germany (up 107 percent over the same period), and much faster than for instance the United Kingdom (up 33 percent), though the UK has its own currency, the British pound. Labor costs, in other words, do not alone dictate competitiveness and the ability of an economy to rely on external demand for economic growth. Spain has a lot of necessary structural economic reforms to carry out, but there is no obvious reason for prices and costs of its goods to have to decline by the 20-30 percent mentioned by professor Krugman for the country to be internationally competitive.
This entry is cross-posted on the Rundown– NewsHour’s blog of news and insight.