PK continues to fight the good fight for Keynesian common sense in the face of resurgent austerity. The austerity front, which brings together Tea Partiers and Tories, blue dogs and Bundesministerien, wants to snuff out last year’s stimulus and force the North Atlantic economy to sink or swim. It’s chances of sinking are frighteningly large. Krugman says we should keep applying fiscal CPR until economic growth is in full recovery and unemployment has dropped—and until the zero lower bound on interest rates no longer binds, and normal monetary policy becomes an option.
There is an enormous hole in Krugman’s argument. A chief worry of the austeritarians is that their country—Britain, Germany, even the US—will be the new Greece, abandoned by creditors and teetering on default. These fiscal deficits are unsustainable, they say, and debt-to-GDP ratios are drifting up into the danger zone. The risk is that financial markets will lose confidence in governments with so much red ink, leading to a spike in interest rates, the dumping of bonds, and national humiliation at best, meltdown at worst. Why wait for this moment, the argument goes, when you can prevent it by bringing fiscal deficits down now?
Krugman’s response is that the creditor flight threat is imaginary. Speaking of the new budget cuts and tax increases in Germany, he writes, “Nor can they claim that markets are demanding austerity. On the contrary, the German government remains able to borrow at rock-bottom interest rates.” This has also been his pitch for the US, which also enjoys lowest-ever rates on its long-term bonds. The markets aren’t worried, so why should we be?
Does anyone else notice that this argument rests on the assumption that low interest rates today guarantee low rates tomorrow? Yes, the US, Germany and England can borrow long-term at firesale prices, but old debt keeps coming up for refinancing, and if market sentiment changes, the effects will be felt immediately. Do financial markets ever swing radically from favoring one asset or currency to panic buying of its substitute? Is there unpredictable herd behavior among investors? Do we have to ask?
The issue is not what markets “think” today, but how exposed we are to their gyrations in the coming months and years. This is the strongest argument of the austeritarians, and Krugman can’t see it. It is entirely possible that we could be in for a period of cascading panics, with money surging to one apparent safe haven, and then another, and then somewhere else, wrecking whole economies in the process. In other words, we have to worry not only about 1937, when premature austerity put an end to economic recovery in the US, but also 1931, when the failure of Vienna’s Kreditanstalt led to a period of devastating currency runs. Now, as then, there is no sufficient international lender of last resort, and any defense would have to be improvised on the fly. Back then, defense failed utterly.
The solution, however, is not fiscal tightening; Krugman is right about that. The starting point for any intelligent analysis has to be the basic accounting identity, that the sum of private sector deficits plus fiscal deficits equals the current account balance. Surplus countries that choose austerity are choosing some combination of decreasing private sector savings and increasing trade surpluses, most likely through declines in national income. They are making life even more difficult for their counterparties. Deficit countries, like ours truly, are in an even worse situation. Fiscal retrenchment means even greater private borrowing, with the only difference, in the short to medium run, coming from the effect of falling incomes on imports. We got into this situation because the private sector, especially financial institutions, were over-leveraged and badly invested; with deleveraging the debt burden was shifted onto governments that stepped into the breach. To withdraw the fiscal lifeline before private wealth-holders are prepared to lend would be catastrophic. We would have unavoidable crises, first in the deficit countries, then in the surplus regions exposed to them.
This is Scylla and Charybdis territory, to be sure. We got here by a long sequence of institutional failures and policy errors, and it will not be easy getting out. I remain convinced that the bailouts of 2008 were deeply mistaken, and that we are now paying the price. (At the time I instead favored the use of public money to create “good, new” financial institutions.) Moreover, no action was taken to address global imbalances, and without this it is difficult to see how growth can resume: the US will no longer borrow the vast sums needed to sustain global demand. (Recent labor action in China is a sign that bottom-up rebalancing may be gathering force—I hope so.) The Eurozone crisis is itself a dilemma of rebalancing on a regional scale.
In short, there is no obvious way out. Austerity is a sure-fire loser, but the risk of distended fiscal deficits in a low- or no-growth world is real. Time is running out to deal with the underlying causes.