Friday, August 22, 2014

The fiscal policy debate: Austerity versus stimulus


AUGUST 21, 2014

It is hard to believe, but almost six years have passed since the fall of Lehman Brothers ushered in the worst economic crisis since the 1930s. Many people, myself included, would like to move on to other subjects. But we cannot, because the crisis is by no means over. Recovery is far from complete and the wrong policies could still turn economic weakness into a more or less permanent depression.

In fact, that is what seems to be happening in Europe as we speak. And the rest of us should learn from Europe’s experience.

Before I get to the latest bad news, let us talk about the great policy argument that has raged for more than five years. It is easy to get bogged down in the details, but basically it has been a debate between the too-muchers and the not-enoughers.

The too-muchers have warned incessantly that the things governments and central banks are doing to limit the depth of the slump are setting the stage for something even worse. Deficit spending, they suggested, could provoke a Greek-style crisis any day now — within two years, declared Mr Alan Simpson and Mr Erskine Bowles about three-and-a-half years ago. Asset purchases by the Federal Reserve would “risk currency debasement and inflation”, declared a who’s who of Republican economists, investors and pundits in a 2010 open letter to former Fed chairman Ben Bernanke.

The not-enoughers — a group that includes yours truly — have argued all along that the clear and present danger is Japanification rather than Hellenisation. That is, they have warned that inadequate fiscal stimulus and a premature turn to austerity could lead to a lost decade or more of economic depression; that the Fed should be doing even more to boost the economy; that deflation, not inflation, was the great risk facing the Western world.


To say the obvious, none of the predictions and warnings of the too-muchers have come to pass. America never experienced a Greek-type crisis of soaring borrowing costs. In fact, even within Europe, the debt crisis largely faded away once the European Central Bank began doing its job as lender of last resort. Meanwhile, inflation has stayed low.

However, while the not-enoughers were right to dismiss warnings about interest rates and inflation, our concerns about actual deflation have not yet come to pass. This has provoked a fair bit of rethinking about the inflation process (if there has been any rethinking on the other side of this argument, I have not seen it), but not-enoughers continue to worry about the risks of a Japan-type quasi-permanent slump.

Which brings me to Europe’s woes.

On the whole, the too-muchers have had much more influence in Europe than in the US, while the not-enoughers have had no influence at all. European officials eagerly embraced now-discredited doctrines that allegedly justified fiscal austerity even in depressed economies (although America has de facto done a lot of austerity, too, thanks to the sequester and cuts at the state and local level). The European Central Bank, or ECB, not only failed to match the Fed’s asset purchases, it actually raised interest rates in 2011 to head off the imaginary risk of inflation.

The ECB reversed course when Europe slid back into recession and, as I have already mentioned, under Mr Mario Draghi’s leadership, did a lot to alleviate the European debt crisis. But this was not enough. The European economy did start growing again last year, but not enough to make more than a small dent in the unemployment rate.

And now growth has stalled, while inflation has fallen far below the ECB’s target of 2 per cent and prices are actually falling in debtor nations. It is really a dismal picture. Mr Draghi and Co need to do whatever they can to try and turn things around, but given the political and institutional constraints they face, Europe will arguably be lucky if all it experiences is one lost decade.

The good news is that things do not look that dire in America, where job creation seems finally to have picked up and the threat of deflation has receded, at least for now. But all it would take is a few bad shocks and/or policy missteps to send us down the same path.

The good news is that Ms Janet Yellen, the Fed chairwoman, understands the danger; she has made it clear that she would rather take the chance of a temporary rise in the inflation rate than risk hitting the brakes too soon, the way the ECB did in 2011. The bad news is that she and her colleagues are under a lot of pressure to do the wrong thing from the too-muchers, who seem to have learned nothing from being wrong year after year and are still agitating for higher rates.

There is an old joke about the man who decides to cheer up, because things could be worse — and sure enough, things get worse. That is more or less what happened to Europe and we should not let it happen here.



Paul Krugman is a winner of the Nobel Prize for economics, and is professor of economics and international affairs at Princeton University.

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