Paul Krugman on the euro-depression

This is a very good paragraph from Paul Krugman:

One last point: the Germans are very proud of their own adjustment between the late 1990s and 2007, during which they emerged from economic doldrums and became very competitive. But that adjustment, from a European point of view, looked like my first figure: German belt-tightening was accompanied by what amounted to a highly expansionary monetary policy, which led to fairly high inflation in Southern Europe. So when Germany asks why other countries can’t do what it did, it isn’t just forgetting that we can’t all run trade surpluses; it’s also insisting that other countries replicate its success while denying them the kind of external environment that made its success possible.

One small quibble, which I think even Krugman would accept.  Replace “highly expansionary monetary policy” with “relatively expansionary monetary policy.” Highly expansionary is 1965-81.  It was relatively expansionary compared with the post-2008 policy.

Krugman also seems to slightly modify his earlier claim that the zero-bound model has applied to the eurozone in recent years:

But as Wren-Lewis says, that’s not what has happened in Europe “” the ECB has in fact been very reluctant to pursue expansionary policies despite all that fiscal austerity, and now “” having waited too long “” it finds itself close to the zero lower bound.

That’s been my position all along; that the eurozone has not been at the zero-bound, but arrived there a few days ago, or at least is very close.

The point, which I guess we should all have been making more clearly, is that all the various things we talk about here “” the extreme slump in Southern Europe, Germany’s failure to narrow its current account surplus, and the slide of the eurozone as a whole toward deflation “” are really aspects of the same story. We have huge forced fiscal contraction in part of Europe, not at all offset by either overall monetary policy or fiscal expansion elsewhere.

So the ECB made a big mistake in 2011 by not offsetting fiscal austerity.  Krugman and I agree on that point.  The eurozone was not at the zero bound, so austerity should not have reduced demand, even using Krugman’s model.  One irony here is that Krugman may be partly right about the fiscal multiplier, but for essentially supply-side reasons.  One problem in 2011 was that inflation was running above target.  And that was partly due to various tax and fee increases designed to close the large budget deficits.  The ECB reacted to these tax increases by raising rates several times in 2011.  In an AS/AD model the tax increases shifted AS to the left, raising inflation and reducing output, and the ECB reacted by shifting the AD curve to the left.  So fiscal austerity was a mistake.

Or perhaps the real problem was the specific type of fiscal austerity.  My analysis, combined with the ECB’s insane preference for inflation targeting, suggests that demand-side fiscal austerity would have been desirable. Raise the employee-side payroll tax by 4 percentage points and lower the employer-side payroll tax by 2 percentage points.  That sort of fiscal reform would have lowered inflation and thus caused the ECB to cut rates in 2011, instead of raising rates.

But unless I’m mistaken, the Krugman/Eggertsson “paradox of toil” model suggests that my proposal to cut employer-side payroll taxes would be a mistake.

PS.  Ryan Avent also has a good post on the German opposition to “inflation.”



12 Responses to “Paul Krugman on the euro-depression”

  1. Gravatar of Geoff Geoff
    11. November 2013 at 16:33

    “One small quibble, which I think even Krugman would accept. Replace “highly expansionary monetary policy” with “relatively expansionary monetary policy.” Highly expansionary is 1965-81. It was relatively expansionary compared with the post-2008 policy.”

    Once again arguing from definitions. In terms of Fed activism, that is, in terms of what the directly changes (reserves) post 2009 has been the most expansionary period in US history.

  2. Gravatar of Benjamin Cole Benjamin Cole
    11. November 2013 at 18:26

    The cult of genuflecting to microscopic rates of inflation has now enveloped the ECB.

    The ECB is, by charter, not responsible for economic growth, but only price stability. That is a debacle unfolding.

    Incredibly, some call for the Fed to also have a “single mandate” and be responsible only for price stability, as measured by a subjective price index.

    That will also be a debacle.

    Independent central banks seem drawn, like moths to a flame, to a cult of price stability, ultimately meaning zero inflation.

    This is extremely bad economics, and even worse governance, but democratic (small d) standards.

  3. Gravatar of Garrett M Garrett M
    11. November 2013 at 19:18

    Spanish stocks have been outperforming, unemployment fell, retail sales ticked positive, RGDP signalling an emergence from recession, and export growth is high. All with the backdrop of massive austerity.

    I agree with Krugman that the austerity was not offset by monetary policy, but how does his model account for Spain’s performance this year?

  4. Gravatar of Zachary Bartsch Zachary Bartsch
    11. November 2013 at 21:10

    Wouldn’t shifting the payroll tax burden have only short term effects since you can’t legislate tax burdens [among supplier and demander] in the long run? And then don’t you face the re-distortion of moving the taxes back to the original levels later? – Unless you simply mean to keep the new fiat mix of payroll taxes. In which case, doesn’t that make it a one-shot policy tool, not available for use many times since you can reduce taxes on one side only so far [ignoring subsidies)(especially if it enters expectations for future policy)?

  5. Gravatar of Vivian Darkbloom Vivian Darkbloom
    12. November 2013 at 01:14

    Sorry for publishing this “above the fold”, but I thought in light of Scott’s earlier post on the subject, today’s post from Bruce Bartlett, “Poverty, Government and Social Class”, would be of interest, for example:

    “One explanation for the difference in perception and reality is that some people technically poor in terms of income may be poor only temporarily. They may have suffered a one-time financial setback or are young and starting out in life. They may be poor, objectively, but don’t see themselves that way.”

    One of the questions I have about that formulation is: which is the “reality” and which is the “perception”?

  6. Gravatar of Jussi Jussi
    12. November 2013 at 05:03

    @Garrett: I think Krugman has been said many times that eventually internal devaluation will work. But internal devaluation was a policy opted by eurocrats. Krugman et al has claimed that there were better alternatives (and I think I agree, looking at yawning employment cap between the US and Euroland).

  7. Gravatar of ssumner ssumner
    12. November 2013 at 06:43

    Ben, Very good post over at Marcus Nunes’ blog.

    Garrett, I am not sure–I’d want to know how Spanish fiscal policy in 2013 differs from fiscal policy in 2012.

    Zachary, Yes, but that’s what you want—only a short term effect. The goal is to overcome the short run negative effect of wage stickiness. In the long run wages should always adjust to equilibrium, and money is neutral.

    Thanks Vivian, That’s a good quotation.

  8. Gravatar of Bob Bob
    12. November 2013 at 09:10

    To know how Spanish fiscal policy changed between 2012 and 13, we have to know what you define as fiscal policy, and where do you want to file the effects.

    There were cuts on pensions to retirees and pensions to people on major disabilities. There were significant cuts to universal healthcare, which now bring longer waiting lists, co-payments, and more drugs that are flat out not covered. VAT went up on many things, especially on the ‘culture’ category. University funding has also been slashed.

    There’s also events that haven’t quite come online yet, but that affect expectations. For instance, subsidies for alternative energies are going away, and university scholarships are cut more or less in half.

    The difficult part is to transform all of this cuts, which you can get from newspapers, into real numbers of expenses cut, year over year.

  9. Gravatar of libertaer libertaer
    12. November 2013 at 09:58

    Benjamin Cole said:
    “The ECB is, by charter, not responsible for economic growth, but only price stability. That is a debacle unfolding.”

    Hm… Draghi -once in an interview- explicitly acknowledged that the ECB is only targeting inflation in the long run (he said that as an excuse for being below target).
    Since NGDP targeting keeps inflation stable in the long run, I don’t see any legal problem with the price stability mandate.

  10. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    13. November 2013 at 05:17

    “””Raise the employee-side payroll tax by 4 percentage points and lower the employer-side payroll tax by 2 percentage points. That sort of fiscal reform would have lowered inflation and thus caused the ECB to cut rates in 2011, instead of raising rates.”””

    In Portugal, the government proposed this a few years back. The result was the single largest “anti-austerity” demonstrations of the last 5 years. The government quickly backtracked.

    It is nowhere near politically feasible in a time of crisis to cut taxes on the employers and raise them on the employees.


    It’s interesting how much of “austerity” has been tax increases, but we never call anti-austerity protests tax protests

  11. Gravatar of ssumner ssumner
    14. November 2013 at 20:07

    Libertaer, Yes, and they also have a mandate to make sure the euro regime is well functioning (I believe), which gives them flexibility to do things in the short run that may save the system, as long as inflation is kept low on average, as you say.

    Luis, Good point.

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