Paul Krugman's Shrillness Rises to 11: "Et Tu, Ken Rogoff?" Origins of the Present Crisis Blogging
Scott Brown Disappoints Yet Again

Against the Financial Times's Editorial on Austerity

The Financial Times editorial on "austerity" yesterday felt like a punch to the stomach, especially coupled with the backup that Gideon Rachman provided for it.

The FT is thoroughly reality-based. Its people are smart. They can do the arithmetic on both the need for long-run fiscal balance and on the devastating effects of premature short-term austerity as well as I can. And yet...

Reacting to this, I asked Paul Krugman a question:

As you know, Paul, ever since I decided to force my 700 Econ 1 students to read Milton and Rose Director Friedman's "Free to Choose", I have been trying to understand why those who claim to be Friedman's intellectual disciples--especially those who hold appointments at the Becker-Friedman Institute--have not been aggressively out there condemning Bush, Bernanke, and Obama for insufficient policy activism. The natural generalization of virtually all of Friedman's work to the current situation is that the task of the government is to Stabilize the Growth Path of Nominal GDP by Any Means Necessary--which means issuing cash and buying stuff that is not a perfect substitute for cash with it until nominal GDP is on its previous growth path.

Yet the ranks of Friedman disciples appear to be limited to Scott Sumner and (perhaps) David Glasner.

And in this morning's FT I read my guru Martin Wolf writing about how for central banks "The immediate task is to manage an exit from the interventions." He does go on to say that "A far greater danger exists of premature retrenchment than of excessive delay..." but the initial sound bit makes me wince. And his colleague the highly-intelligent and usually reliable Gideon Rachman denounces you for shrillness and warns us that "the assumption of unlimited Dutch and German creditworthiness" to support fiscal expansion "is unconvincing".

It seems to me that we have lost not just those professional Ph.D. economists who became addicted to DSGE and RBC models and lost touch with reality, but have also lost a good many who either want to retain contact with reality or who ought to be willing to worship Milton Friedman as their guru. And I am still not sure why, or how...

Paul's reply:

My best theory here is that it's political and sociological: conservative-leaning economists who should know better are driven by peer pressure to suppress their better instincts.

Think about Greg Mankiw and inflation. Early on in the Lesser Depression Greg came out for inflation -- fairly high inflation! -- as the solution, to give us negative real interest rates. But he encountered a firestorm of criticism from his political allies -- and went silent.

The point is that even among academics with tenure and established reputations, there is apparently enough leverage in the hands of the enforcers of right-wing orthodoxy that they end up bowing to the reign of error.

As for Rachman: I think this is a subtler form of peer pressure. And for what it's worth, Ryan Avent has already written the devastating reply to Rachman I haven't had time for because I'm on Reddit!

Ryan Avent:

THE backlash to the backlash against austerity seems now to be underway. For months, if not years, complaints have grown that the euro-zone's austerity-first approach to the crisis is somewhere between inadequate and counterproductive. That message now seems to be winning converts.... Perhaps predictably, the pushback is on. The Financial Times' Gideon Rachman captures the essence of the counterargument in a piece titled "No alternative to austerity". What Mr Rachman manages to do quite effectively is illustrate how muddled the conversation has become....

Mr Rachman does an excellent job constructing the framework through which most serious observers see the crisis. Unfortunately, it's deeply flawed. Let's start with his last point: do unsustainably high market interest rates signal a need for austerity? It would be peculiar if they did; Spain's fiscal and growth prospects aren't demonstrably worse than those in other places where markets are happy to lend cheaply. The problem, rather, is that Spain lacks its own currency and has therefore become stuck in a nasty loop in which financial concerns hurt growth and sovereign yields, and high sovereign yields lead to an austerity push which hurts growth and financial conditions.

Mr Rachman is right that, left on its own, Spain has no choice but to react to high yields by embracing drastic austerity in order to reduce its borrowing needs. The question facing Europe is not whether this is a true dynamic—obviously it is, and it's strange that Mr Rachman would see a need to point it out. The question is whether it should be allowed—or encouraged—to play out, given the euro zone's deep commitment to economic integration. That's what the anti-austerity folks are complaining about. Enforced rapid, deep austerity in places that don't obviously need it entrenches a bizarre halfway integration that's ultimately doomed to fail.

What, then, are the alternatives to austerity? Well, first up would be an integration that would help break the diabolical loop now gutting the periphery. Creating a euro-zone-wide safe asset and a euro-zone-wide set of institutions to stand behind damaged banks would help accomplish that.... Perhaps fiscal stimulus is out of the question, even in Germany and the Netherlands. One puzzling mistake Mr Rachman makes is in implying that the only fiscal alternative to austerity is stimulus; in fact, less austerity is also a decent option. Less austerity would be entirely appropriate in Spain, where gross debt levels remain low by rich world standards. It would be appropriate in Germany. It would be appropriate in lots of places not called Greece or Portugal....

Of course, structural reforms are necessary. If the German labour market is running too hot (maybe it is; this is increasingly in doubt), leading the ECB to conclude that more easing would merely generate rapid wage inflation, then structural reforms to boost mobility across borders would be very helpful. But structural reforms are not an inseparable part of some reform cocktail that necessarily includes austerity. On the contrary, structural reform and adequate demand are two great tastes that taste great together: without some wage inflation in Germany, efforts to boost Spanish mobility won't succeed in generating sufficient migration.