Krugman’s blog, 7/22/15

There were two posts yesterday.  The first was “The Half-Lives of Others (Wonkish):”

What about Ireland? That’s what some people have been asking me; they’re under the impression that Ireland is a success story for austerity, and that this success is somehow a refutation of the broadly Keynesian account of the economy I’ve been giving. So I guess some clarification is in order.

As it happens, Simon Wren-Lewis has recently taken this very question on, and in a way I don’t have much to add. But maybe it will help to say more or less the same thing, but differently.

First of all, Ireland is a success only in a relative sense. Yes, it has done better than Greece, but it suffered a prolonged, very severe slump. It is growing again, finally — but that doesn’t undo the reality of a large price paid to get to this point.

Still, it is growing, and fairly fast at this point. Isn’t this something that wasn’t supposed to happen? Actually, no. If you apply a textbook Keynesian model – literally, the one in the best-selling international text, which happens to be Krugman, Melitz, and Obstfeld – it tells a story that looks a lot like Irish experience.

That textbook model can be described with the three equations shown, in which all variables are shown as deviations from their long-run equilibrium. First, the output gap y is determined via a multiplier effect by the structural budget balance B and the level of net exports NX. Second, net exports are determined by the real exchange rate; if we take the nominal exchange rate as given (e.g., if you’re on the euro), and also take foreign prices as given, this is determined by the domestic price level p. Finally, we have a rudimentary Phillips curve, in which the rate of inflation depends on the output gap.

Taken together, these imply the fourth equation, which shows how output self-corrects over time. In words: if the economy is depressed, it will experience deflation, perhaps absolute but in any case relative to its trading partners; this will gradually improve competitiveness, causing next exports to rise and the economy to converge back to normal. The rate of convergence will depend on three parameters: the multiplier, the sensitivity of the trade balance to the real exchange rate, and the sensitivity of inflation to the output gap.

I’ve written down some plausible guesses about these three parameters; they imply that the process of internal devaluation will, left to itself, correct 22.5 percent of an output gap over the course of a year. Alternatively, they imply that the half-life of a deviation of output from potential will be a little over three years.

But, you say, we’re more than 5 years into the euro crisis. Shouldn’t it be mostly gone? No, because austerity wasn’t put into effect all at once. Instead, countries faced several years of fiscal consolidation before there was a pause that permitted growth to resume.

The figure shows a hypothetical example that is meant as a sort of stylized Ireland. I assume that a fiscal tightening equal to 6 percent of potential GDP takes place over the course of three years; the cyclically adjusted balance then stabilizes, with no further tightening. What you see is a large economic downturn as long as the screws are being tightened, but a significant recovery once this stops. Again, this is just standard Keynesian open-economy macro: over time a depressed economy gains competitiveness, so that in the long run recovery happens. But in the long run …

Yesterday’s second post was “Annoying Euro Apologetics:”

Are there good arguments against the proposition that the creation of the euro was an epic mistake? Maybe. But the arguments I’ve been hearing lately are really bad. And they’re also deeply annoying.

One argument I keep seeing is that economist critics like myself don’t understand that the euro was a political and strategic project, not merely a matter of economic costs and benefits. Yes, I’m a dumb uncouth economist, completely unaware of the role of politics and international strategy in policy decisions, who never heard of the European project and its origins in the effort to put Europe’s legacy of war behind it, not to mention strengthen democracy in the Cold War.

Well, actually I do know all about that. The point, however, is that while the European project has at every stage combined economic objectives with broader political goals – it’s about peace and democracy through integration and prosperity – the project can’t be expected to work unless the economic measures are a good idea in and of themselves, or at least a non-catastrophic idea. What happened in the march to the euro was that European elites, in love with the symbolism of a single currency, closed their minds to warnings that currency union – unlike the removal of trade barriers – was at best ambiguous in its economic logic, and arguably, even ex ante, a very bad idea indeed.

An alternative argument, which we’re hearing from depressed European economies like Finland, is that the short-term costs of inflexibility are outweighed by the supposedly huge gains from greater integration. But where’s the evidence for these huge gains? In this article, they’re said to be demonstrated by Finland’s strong growth before the recent crisis. But is it plausible to give credit for the Nokia boom to the single currency?

Well, the chart shows a comparison I find interesting, between Finland and its neighbor Sweden, where a referendum in 2003 rejected euro membership. (I remember that vote: Swedish friends who shared my worries about the euro phoned me in the middle of the night to celebrate.) For both countries I use 1989 as a baseline; that was the year before the great Scandinavian slump of the 1990s, brought on by runaway banks and a huge housing bubble.

Total economy database

After that slump, Finland experienced a long stretch of solid economic growth. But so did Sweden, and it’s hard to see any real difference in their degrees of success. There’s certainly nothing there to indicate that euro membership was crucial to growth. Since 2008, on the other hand, Sweden has – despite bobbling its monetary policy – done much better.

As I said, maybe there are good arguments against the proposition that the euro was a mistake. But pointing out that politics matters, and economies grow, doesn’t cut it; these aren’t the factoids you’re looking for.

Tags: Krugman