Origins of the Euro Crisis by Krugman

Reminds me of the 1997 East Asian financial crisis and others have pointed to the Latin American debt crisis of the 1980s.

Greece might default.

For the moment, Greek officials are adamant that neither a default nor a euro exit and devaluation is in the cards. One senior policy maker in Greece’s Finance Ministry, who declined to be identified because of the delicacy of the matter, even offered to send his questioner a case of 2005 Dom Perignon Champagne if Greece ever repudiated its debt.

But close followers of Greece’s budget dynamics point to the fact that, despite the country’s deficit woes, by next year Greece is likely to have achieved a primary budget surplus, meaning that after taking out the high levels of interest it pays on its debt, it will be running a surplus.

History shows that a country tends only to take such a drastic step as cutting ties with its international lenders when it has tightened its belt enough to achieve a budget surplus, and it is only payments to its bankers that is keeping it in the red.

Such was the case in most of the recent country defaults, including Argentina, Ecuador, Indonesia and Jamaica, economists at the I.M.F. found in a paper published last year that addressed when a country finds its interest is served by default.

“My view is that it is very much in Greece’s interest to default now, as there is no prospect that it can repay its debt,” said Desmond Lachman, a former I.M.F. economist at the American Enterprise Institute. “If it is inevitable that an insolvent Greece is going to have to restructure, it would be better for Greece to do it now.”

Inflated Worries by Laurence Meyer


The Austerity Delusion by Krugman

 Krugman blogs:

The usually well-informed Ezra Klein says something odd this morning:

In 2007 and 2008 we had a major financial crisis. That led to a wrenching recession. But what killed the recovery was the European debt crisis. It was proof that there wasn’t just one risk that the system hadn’t properly accounted for, but many risks. And in a fragile global economy, the impact of any negative event was going to be magnified.

I don’t know where Ezra got that, but it’s just not right. It’s not as if we had a solid recovery, then Greece came along. We never had the basics for self-sustaining recovery in place: aside from the stimulus and inventory bounce, demand remained weak. And financial jitters from the eurozone crisis had nothing to do with the US slowdown; growth is flagging because both the stimulus and inventory effects are fading.

I think it's an open question. Bernanke said the same thing in his June testimony. My guess is that it's all of the above: the stimulus and inventory effects are fading and the European sovereign debt crisis happened. I'm not sure but I would guess that it pushed up the dollar and made businesses and consumers more cautious. No doubt it helped the austerians rhetorically. They could now point to Greece as example of what could happen to a country that wracks up too much debt.

Update: Ezra Klein repsonds

But a lot of the economists, business types and policymakers I've talked to have pinned the European debt crisis as a moment when whatever confidence various players had in the recovery collapsed. It was a whole new world moment: We hadn't just gone through one horrible, unlikely event and now we were recovering, and people should plan for a slow return to normal. The debt crisis was emphasized that there are a lot of risks out there and the world economy is vulnerable to them. The danger for businesses looking to invest wasn't just that demand could come back slowly but that everything could totally fall apart.

My guess is Krugman would dismiss that as rationalization. If government had responded to the crisis correctly and the economy was gaining more jobs and people were buying more things, businesses would be investing to meet the demand. And I agree with that. But in the absence of the correct government response, there's certainly a range of possible ways the private sector could've reacted, and I think it's plausible that their extreme caution is partly a response to seeing the world economy as vulnerable to all sorts of unpredictable shocks, which is leading them to wait for much more solid evidence of recovery than might otherwise be the case.

On the other hand, Krugman has a Nobel, and I, well, don't.

Along with the deleveraging in the economy and not enough aggregate demand, I would guess another problem is "over"-demand for safe assets because people are nervous, in part because of the lack of aggregate demand. The European sovereign debt crisis would have added to this nervousness, unlike, say, Obama's tax and regulatory policies.  But as Klein says, I don't have a Noble either.

Helicopter Ben Is Monitoring the Situation
(or waiting on the private sector)


Krugman's thoughts on Bernanke's testimony.

Bernanke says moderate growth will continue and the economy will improve very slowly. He says we're not Japan because our economy has higher productivity and our banking sector is in much better health than theirs was. He said consumer spending was increasing.

The IMF is forecasting unemployment of 9.5 percent until 2012, whereas the Fed is predicting that the economy will continue to heal (see above). However Bernanke admitted a lot uncertainty exists and will "get to the chopper" if need be.

About Europe, Bernanke said:

One factor underlying the Committee's somewhat weaker outlook is that financial conditions--though much improved since the depth of the financial crisis--have become less supportive of economic growth in recent months. Notably, concerns about the ability of Greece and a number of other euro-area countries to manage their sizable budget deficits and high levels of public debt spurred a broad-based withdrawal from risk-taking in global financial markets in the spring, resulting in lower stock prices and wider risk spreads in the United States.

But Europe has seem to stabilized and he highly doubts that Greece will default. Maybe the Euro isn't dead after all. About the Federal deficit, he didn't seem terribly concerned. The government shouldn't withdraw stimulus until the private sector starts taking over supplying demand.

Bernanke also applauded the "landmark financial regulation legislation" Obama signed this morning.

Obama was also able to get the unemployment benefits extension through the Senate today.

Krugman was absolutely right about the stimulus enacted after Obama entered office. It was too small.

DeLong writes:

Q: Will President Barack Obama's "recovery summer" convince voters the $787 billion stimulus package is pulling the economy out of recession?

My Answer: The problem is that the stimulus package Obama proposed was about 2/3 the size that Obama's economic technocrats thought appropriate in December of 2008, that the marginal votes needed in Congress--Snowe, Nelson, et cetera--cut its effectiveness down to half and had the bargaining power to do so because every single other Republican thought their job #1 was to make Obama look like a failure, and that the magnitude of the financial shock to the world economy turned out to be about twice as big as we were estimating in December 2008.

Thus we did about 1/4 of the job. It was clear relatively early that we had done about 1/4 of the job. Even on February 15, 2009, Mark Zandi--who had been John McCain's chief economic advisor during the 2009 campaign--was out there publicly saying that it was clear that we had not done the whole job.

Given that we did only 1/4 of the job, it looks like the stimulus has been quite effective: unemployment has stayed under 10%.

As an Obamabot, I understand the obstacles he was facing in early 2009. The question I have - and I honestly I don't know the answer - is should Obama and his economic advisors laid this out in early 2009 and/or should they say this now?

I'm leaning towards the affirmative, however, in 2009 there were a lot of "unknown unknowns" like the impending European Debt Crisis, the BP oil disaster, and known unknowns like Fed policy and market behavior. Perhaps the best policy is get what you can and hold off on the predictions.

The Celtic Tiger

The New York Times has an excellent front-page, above-the-fold article on Ireland's economic troubles today.

Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes, the type of austerity measures that financial markets are now pressing on most advanced industrial nations.

...

Rather than being rewarded for its actions, though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession.

Joblessness in this country of 4.5 million is above 13 percent, and the ranks of the long-term unemployed -- those out of work for a year or more -- have more than doubled, to 5.3 percent.

The budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3 percent of gross domestic product last year -- worse than Greece. It continues to deteriorate. Drained of cash after an American-style housing boom went bust, Ireland has had to borrow billions; its once ultralow debt could rise to 77 percent of G.D.P. this year.

...

Mr. Honohan predicts growth could revive to a rate of about 3 percent by 2012. But that may be optimistic: Ireland, as one of the 16 nations in Europe that has adopted the euro as its common currency, is trying to shrink the deficit to 3 percent of G.D.P. by 2014, a commitment that could weaken its hopes for recovery.

Dean Baker lauds the article but adds:

It also might have been worth talking to an economist who could have pointed out that it is not just markets that are forcing Ireland to go the austerity route, it is the European Central Bank (ECB). 

The ECB, like the Fed in the United States, could adopt a more aggresive policy of supporting member states governments. For example, the ECB could buy up large amounts of member state debt and offer extensive guarantees. This would allow Ireland, which had run budget surpluses and had a low national debt before the collapse of its housing bubble, more time to re-orient its economy. Given the huge amount of unemployment and excess capacity in the European Union, there is little risk of inflation from going this route.

This otherwise good piece does a disservice to readers by implying that markets are forcing this suffering on the Irish population. It is the decisions of the ECB that is leading to this suffering.

Krugman blogs:

That’s why the Irish debacle is so important. All that savage austerity was supposed to bring rewards; the conventional wisdom that this would happen is so strong that one often reads news reports claiming that it has, in fact, happened, that Ireland’s resolve has impressed and reassured the financial markets. But the reality is that nothing of the sort has taken place: virtuous, suffering Ireland is gaining nothing.

Of course, I know what will happen next: we’ll hear that the Irish just aren’t doing enough, and must do more. If we’ve been bleeding the patient, and he has nonetheless gotten sicker, well, we clearly need to bleed him some more.

Yglesias comments:

But the lesson is still clear enough--what gives confidence to investors is prospects for growth, and what countries need to do to instill confidence is to adopt pro-growth policies. The United States can get away with more short-term borrowing, and will ultimately have an easier time paying off the debts we’ve already accumulated if the economy grows.

Dean Baker on David Brooks's magical thinking.

In his worst column so far this year, Brooks writes:

Some theorists will tell you that if governments shift their emphasis to deficit cutting, they risk sending the world back into recession. There are some reasons to think this is so, but events tell a more complicated story. 

A theorist named Ben Bernanke, chairman of the Federal Reserve Bank who was appointed by Bush and kept on by Obama, i.e. the most powerful man in the federal government, said yesterday that "This very moment is not the time to radically reduce our spending or raise our taxes, because the economy is still in a recovery mode and needs that support."

For example, retail sales declined in May. This is just one month, but it's a weak report.
Brooks:

Alberto Alesina of Harvard has surveyed the history of debt reduction. He’s found that, in many cases, large and decisive deficit reduction policies were followed by increases in growth, not recessions. Countries that reduced debt viewed the future with more confidence. The political leaders who ordered the painful cuts were often returned to office. As Alesina put it in a recent paper, "in several episodes, spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions."

Someone should Fisk that paper. At the very beginning of his column Brooks writes "Sixteen months ago, Congress passed a stimulus package that will end up costing each average taxpayer $7,798. Economists were divided then about whether this spending was worth it, and they are just as divided now."

And then a couple of paragraphs later "Over all, most economists seem to think the stimulus was a good idea..." Were economists divided into two camps where most thought the stimulus was a good idea and a minority of ambitious, know-nothing suck-ups didn't?

Paul Krugman on Chermany.

You know the answer, don’t you? Yep: everyone is counting on the US to become the consumer of last resort, sucking in imports thanks to a weak euro and a manipulated renminbi. Oh, and while they rely on US demand to make up for their own contractionary policies, they’ll lecture us on how irresponsible we’re being, running those budget and current account deficits.

new unemployment claims fell

A Labor Department report Thursday said new claims for unemployment fell by a less-than-forecast 3,000 to a seasonally adjusted 456,000. While that figure fell short of economists’ forecast for a drop to 448,000, investors were heartened by data showing total claims last week dropped by the largest amount in almost a year. Total unemployment benefit rolls fell by 255,000 to 4.5 million.

The drop in total claims provides some hope that laid-off workers are starting to find new jobs. It was welcome relief after the Labor Department said last week that private employers slowed their hiring in May to the lowest levels since January.

In response to a question from Representative Paul Ryan of Wisconsin, Bernanke wasn't as dire as the House Republicans' point man on the budget:

"If markets continue to stabilize, then the effects of the [European sovereign debt] crisis on economic growth in the United States seem likely to be modest," Mr. Bernanke testified. "Although the recent fall in equity prices and weaker economic prospects in Europe will leave some imprint on the U.S. economy, offsetting factors include declines in interest rates on Treasury bonds and home mortgages, as well as lower prices for oil and some other globally traded commodities"

Flight to Treasury Bonds wasn't supposed to happen.

It is also sobering that a vast majority of economists and market strategists were forecasting a different chain of events. Treasury yields were universally expected to be rising, not falling, as the United States recovered from a deep recession. The domestic economy is, in fact, growing, and corporate profits have been rising, but the European crisis has overturned many expectations.
...
But Mr. Knapp had thought that the stock market decline would be set off by a tightening of monetary policy by the Federal Reserve, which has operated on an emergency basis since the onset of the financial crisis in the United States. The Fed hasn’t tightened. Instead, to keep the economy stable in the face of Europe’s problems, it has held short-term interest rates near zero. In addition, it reopened emergency swap lines with European central banks last month, to help maintain liquidity there.
...
Mr. Davis said that there is a very "strong correlation" between low Treasury yields and subsequent strong economic growth. And there is a weaker but still significant connection between low yields and high stock returns.

In short, at current prices, it would appear that there is some reason for long-term optimism for stock investors.

(via DeLong)

Geithner urges G-20 nations to spur domestic demand.

The United States wants countries with trade surpluses, like Germany and China, to stimulate domestic demand, fearing that tighter fiscal policy will impede growth and endanger the still-nascent recovery.

"Fiscal consolidation should be 'growth-friendly,'" Mr. Geithner told reporters, saying the "pace and composition of adjustment" should vary across countries.

Krugman responds to the G-20 communiqué:

But don’t we need to worry about government debt? Yes -- but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt. Costly, because it depresses the economy further; ineffective, because by depressing the economy, fiscal contraction now reduces tax receipts. A rough estimate right now is that cutting spending by 1 percent of GDP raises the unemployment rate by .75 percent compared with what it would otherwise be, yet reduces future debt by less than 0.5 percent of GDP.

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered -- specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound.