Ireland: Keynsianism's Worst Nightmare

Question: what keeps Paul Krugman up at night? Answer: not being able to perform fiscal stimulus because of a skittish bond market. Unfortunately for the Irish, this is the situation they now find themselves in. As Krugman explains:

to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump.

And it’s that closing off of policy options that I’m afraid might happen to the rest of us.

And how did the Irish get in this predicament? Again back to Krugman:

On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking, with a balanced budget and a low level of public debt. But the government’s revenue — which had become strongly dependent on the housing boom — collapsed along with the bubble.

Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers. Last September Ireland moved to shore up confidence in its banks by offering a government guarantee on their liabilities — thereby putting taxpayers on the hook for potential losses of more than twice the country’s G.D.P., equivalent to $30 trillion for the United States.

The combination of deficits and exposure to bank losses raised doubts about Ireland’s long-run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies.

Hence the harsh new policies. Earlier this month the Irish government simultaneously announced a plan to purchase many of the banks’ bad assets — putting taxpayers even further on the hook — while raising taxes and cutting spending, to reassure lenders.

Luckily for the United States, our banking sector isn't so outsized that our too-big-to-fail institutions are too-big-to-save. Small comfort. And the United States' government debt-to-GDP ratio is at a lower starting point than that of most European nations, so we have quite a bit more runway than our friends across the pond. Still, if the PPIP is as inefficient and ineffective as its critics fear, then every day could seem like St. Paddy's Day: we'll have run up too much debt to save the banks to commit to any other spending, cutting vital counter-cyclical programs at the worst moment. Again, back to Krugman:

For now, the United States isn’t confined by an Irish-type fiscal straitjacket: the financial markets still consider U.S. government debt safer than anything else.

But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to G.D.P. than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market.

Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right.

And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks.

The brouhaha over the AIG bonuses will be remembered fondly as a time of sober judgment if we turn Irish, and bail out the bankers, while cutting services for the public at large. But even this obvious political reality seems unlikely to change policy towards the banks - after all, it's much easier to simply cross your fingers and hope the banks can earn their way out of this crisis a la 1982, than take serious steps to restructure them. Japan circa 1995, here we come!

Macro-Economists Have No Good Multiplier Estimates

This discussion between Mark Thoma and Scott Sumner touches on two key issues: first, this is a balance sheet recession; and second, macro-economists do not have good multiplier estimates for fiscal policy in a depressed economy.

Regarding the difference between the current downturn and garden variety business cycle recessions, Thoma explains that insolvency is the distinguishing characteristic. While policymakers have mostly focused on the banks, household balance sheets are in bad shape as well, as the following chart of household debt-to-GDP shows.

Since households are still more or less swamped in debt, they will likely use any tax cuts to save or pay down debts. While this won't prop up aggregate demand, it should speed up recovery. Indeed, since consumer spending makes up such a large part of the American economy - some 70% at the peak of the bubble - there will not be a sustained recovery until households regain their financial footing. And as tax cuts will help households pay off what they owe quicker, there is a compelling argument for including them in any stimulus. Nonetheless, to prevent aggregate demand from completing collapsing into a deflationary spiral, Thoma argues for the necessity of fiscal stimulus.

And here's where things get interesting. Sumner and Thoma agree that macro-economists have no good estimates for fiscal multipliers. As Sumner explains, under normal economic conditions, if fiscal policy created an inflationary pressure, the Fed would raise rates in order to meet its inflation targets. In other words, monetary policy would counteract fiscal policy to prevent the economy from heating up too much. Consequently, we don't have good estimates of what the multipliers of fiscal policy would be, holding all else equal. Of course, today we are in a situation where the Fed is desperately trying to create inflation, so we do not have to worry about fiscal and monetary policies working at cross purposes. But when economists argue about the different multipliers of different types of tax cuts or spending, they are largely flying blind, relying on theory rather than empirical tests. In other words, economics is much, much less a science than its adherents usually like to pretend.

German Hyperinflation Did NOT Occur During Great Depression

Here's an example of bad history informing bad policy preferences.



The historical trauma of hyperinflation certainly seems to have contributed to German wariness about aggressive fiscal policy - but the infamous Weimar hyperinflation occurred during 1923, not during the Great Depression. Furthermore, out of control government spending did not cause the German hyperinflation. Rather, the Weimar government printing money to pay reparations, as well as benefits to workers striking against the French occupation of the Ruhr region, caused the runaway inflation. Since German industry ground to a halt with the general strikes, they had no goods to trade for capital. To make up the difference, they printed money, with disastrous consequences. This does not prove the case against Keynsian deficit spending; merely it proves that you cannot print money and pretend you have a real economy when you in fact do not. It would be helpful if our media - and the Germans themselves - understood this difference when debating the merits of fiscal stimulus.