Thursday, June 10, 2010

Economic Masochism?

This is the phrase used by Paul Krugman to describe Europe's current wave of government budget cutting and austerity.

In part he is right - some of the measures taken by governments are plain stupid and seem designed to force economies into a more severe contraction.

The Romanian government is a case in point.  It needs to cut spending, but the way it is making the cuts is plain dumb.  The hundreds of thousands of people fraudulently claiming disability pensions are untouched.  The hundreds of thousands of people fraudulently claiming government salaries are untouched.  The wasteful and bloated government bureaucracy is untouched.  Instead, Premier Emil Boc has come up with the wonderful idea of cutting public service pay across the board by 25%, a measure that will force some into poverty and others into deeper corruption.  The smartest folks will leave the public service and seek better paid work in the private sector, leaving the intellectually challenged to run Romania.

While I agree with Mr Krugman that the way some European governments are cutting deficits is masochistic, I disagree with him about the need to cut deficits.  With national deficits and debts already extremely high as percentages of GDP and no sign of economic growth, Keynesian pump-priming is now impossible, at least for the southern amd eastern Europeans.  With interest rates already low, monetary policy is of no help.  The only thing these countries can do is to develop credible plans to restore budget surpluses over the medium term.

That means either reducing spending or increasing taxes, both of which will be contractionary.  Of the two, I prefer reducing spending, basically because government's share of the economy in Europe is currently way too high and this cramps the economic liberties of individuals and companies.

Spending should be reduced intelligently, however.  Cut down on benefit fraud.  Close government agencies that do nothing useful.  Merge others.  Flatten management structures.  Rewrite laws to eliminate unnecessary bureacracy.  Privatise non-core services.  Introduce user-pays where appropriate.  Have the private sector build, own and operate infrastructure.  Sell off state assets to fund pensions.

The 2010s are going to be a long, difficult decade as we sort out all of our various issues with the credit overhang, trade imbalances, demographic change, environmental change and the decline of oil.  The next couple of years will be particularly hard as government spending falls, and with it demand and economic activity.

There is light at the end of the tunnel, however.  With enlightened decision making, European economies could emerge from the recession with slimmed down public bureaucracies, more flexible labour markets, more open and liberal economic structures, greener energy solutions and a class of former public servants who have entered the private sector and established small, productive businesses.  These changes will lay a firm foundation for solid, productivity-based economic development in the 2020s.

PS:  What Mr Krugman and many economic commentators are failing to point out is that the US is in a very similar boat, running a very high deficit (10.6% of GDP) and a very high national debt ($13 trillion).  For the moment, the markets are focussed on Europe and are giving the US a longer leash.  Maybe this is because they believe the Obama deficit reduction plan, maybe it's because the US is registering a degree of (stimulus-based) economic growth, maybe it's because the US has a somewhat better demographic outlook?  Whatever, it's only a matter of time before the US has to start cutting just as Europe is now.  Any schadenfreude will be short-lived.


  1. Zimbru, I'm reading prof. Krugman's blog on a daily basis, so I have to make a few notes.

    Precisely because interest rates are at the zero bound, we cannot have fiscal austerity; unless we all want to end up like Japan. Expansionary monetary policy is used to OFFSET contraction from fiscal austerity, in order to achieve a balanced budget without depressing even more the economy. That is what Krugman calls "masochism": the idea that many countries are willingly risking to move in a double-dip recession in order to have a balanced budget. Just look at Estonia: they have 20% unemployment and suffered a 20% fall in GDP, yet it has virtually no debt. Was it really worth it? Sure they had to in order to join th euro zone, but other countries are doing it anyway. In Romania it's a slightly different story: I think that at this point it's pretty dumb not to have a progressive income tax, like any other serious country. Instead they prefer to make deep cuts in salaries... as Strauss-Kahn said, their choice, not mine...

    This run for fiscal responsibility reminds me of an old cartoon:

    Krugman doesn't say we don't need to reduce public spending; he just says we shouldn't do it NOW, but after the economy has recovered. That way, we will be able to offset the fiscal austerity with an appropriate monetary policy, as interest rates will be higher by that time. Moreover, Krugman says fiscal austerity is not only costly to the recovery, but deeply ineffective, as by depressing the economy, it will reduce even further future receipts.

    About the differences between USA and EU countries, he actually did talk and quite a lot. Basically, it's about the euro: when Greece went in trouble, they couldn't do a vital thing that US, UK or Japan can: devalue. Markets aren't crazy about the US debt, simply because the US dollar can be devalued, which is like an automatic adjustment. You'll find more technical explanations from Krugman's blog. By the way, Japan has been runnnig severe deficits and debts for decades now, but markets just don't care..

    Here's just one of the many links:

  2. Some excellent comments, however I would counter that I don't see a strong, sustainable private sector demand-driven recovery any time soon, at least in Europe and North America. Personal balance sheets will need to be repaired first, and that will take a number of years. In the meantime countries cannot continue running 10%- of-GDP deficits.
    Japan is a peculiarity, I think; it's debt is tolerated because of (a) its strong export base and (b) its deep pool of private savings.
    On the devaluation issue, the US actually has a similar problem, but it hasn't come to the fore due to the weak US dollar. As the US Dollar strengthens, economically weak exporting states will start to feel the pinch just as southern Europe has.