Time to End the Big Lie That’s Crippling Europe

Having lavished some praise on Paul Krugman some time ago for the clarity of his explanation of how and why the economics profession missed the onset of the global credit crisis in 2007-08, it pains me to say that his latest book, which he was in London promoting last week, is also an excellent read. Nobody who reads End This Depression Now! can fail to understand his prescription for avoiding what he fears is a deepening – but eminently avoidable – economic slump around the world. Whether it adds up to an effective policy prescription is another matter.

There are not many books by Nobel prize-winning economists that pass the crucial tests of clarity and readability, but this one certainly does. Mr Krugman’s solution to the crisis is that only a massive injection of government stimulus will avoid a massive economic depression in the US and Europe. If you thought that the problem we face is one of too much government spending, he is saying, then please think again.

The austerity measures being pursued by the coalition government in the UK, and the much tougher measures being forced upon the struggling southern European members of the eurozone are, he bluntly told an audience in London last week, a disaster, because they are only making the crisis worse. The mistake the UK government is making, and more so the one the Germans are misguidedly imposing on their southern European neighbours, is to believe that the underlying problem is one of fiscal irresponsibility when the real problem is one of insufficient demand.

This, says Mr Krugman, is the Big Lie that is helping to bring Europe to its knees and is preventing the US economy from recovering more quickly. “The road out of depression and back to full employment is wide open. We don’t have to suffer like this,” he concludes his book. The solution, in his view, lies in governments making up for the inevitable private sector deleveraging that follows every debt-fuelled credit bubble with offsetting increases in public spending to keep the economy moving until the spectre of debt deflation has been averted.

Only when that has been achieved should governments revert to fiscal rectitude – and yes, if that means somewhat higher inflation along the way, to erode the real value of the country’s outstanding debt, so be it. If financial repression has the effect of punishing the prudent and rewarding the reckless, that too, in the grander scheme of things, he seems to be saying, is a price worth paying. The important point is that the scale of the response, he argues, needs to be proportionate to the scale of the crisis. The Obama administration’s $747bn stimulus package in 2009 was way too small, he says, and it is why the US recovery has been feebler than many hoped.

More interesting to me than the debate over the value of this classical Keynesian set of remedies is the light that his polemical analysis throws on the current behaviour of investors. First, his argument that policy responses need to be proportionate to the scale of the problem is surely right, and is implicit in the markets’ reaction to the unfolding eurozone crisis.

Whether or not you think that the eurozone can or should be saved, it will certainly require a more concerted and united effort than the region’s political leaders have managed to achieve thus far. (By the same token, Mr Krugman’s criticism of the UK government’s austerity programme would be more convincing if its plans did in practice involve a dramatic reduction in public spending, rather than some minor tinkering with planned future increases that are trivial in the context of the country’s overall debt position).

Second, even though I doubt most market participants share Mr Krugman’s analysis, it is hard to avoid the conclusion that the bond market is implicitly vindicating one of his central theses, that fiscal imbalances are not the primary issue of investor concern, at least for now. The risk of default in countries that are effectively debarred by their membership of the euro from currency devaluation is evidently regarded as a far greater threat than the mere existence of public sector books that do not look like balancing, either now or in the foreseeable future.

How else to explain a world in which, as Mr Krugman points out, countries such as the UK, Japan and the US, which have sustained much higher levels of debt than many of the troubled eurozone members for years, should now be regarded as the safest of havens by investors, with bond yields that fell last week to new or near-new all-time lows, and remain either negligible or negative in real terms across an ever expanding section of the yield curve? It makes no sense, but to the extent that it appears to confirm the validity of Mr Krugman’s premise, it is an open invitation to policymakers to pursue the kind of policies that the self-same bond investors may well have cause to regret in years to come.