The Perils of Partisan Commentary

by Ingolf Eide

I don’t doubt Krugman’s right to suggest we’re in the early stages of a Third Depression. The last few years have been a first instalment in what will prove to be a drawnout, volatile and painful downturn. I also agree it’s “primarily [about] a failure of policy”. Where we differ is on the nature of these failures.

First though, some points of agreement.

Krugman was vocally unhappy about much of what took place during the boom years. He railed against the excesses of the financial system, and the deregulatory zeal that allowed it to run so completely out of control. He expected it all to end badly, although perhaps not quite to the degree it has. He’s also consistently argued that deflation, not inflation, is the greatest danger for the foreseeable future.

No argument, from me at least, on any of this. Nor do I really want to argue with his critique of the simplistic view put forward by those he terms “the apostles of austerity”; namely, that cutting spending and/or raising taxes won’t bring on further short-term pain. It will. To pretend otherwise is disingenuous at best.

The real question is whether there’s any way to avoid this pain that doesn’t bring even more disastrous consequences in its wake. After all, it isn’t hard to make the case that our current impasse is the direct cumulative result of decades of repeated refusals to wear short-term pain. This, in my view, is where the true policy failures occurred (although there’s been no shortage of errors in the various responses to the crisis as well). For anyone with a similarly obsessive interest in these matters, they’re explored in greater depth in “Money, Credit and Financial Systems: Are Crises Built into Their DNA?”.

I don’t share Krugman’s passionate belief in the benefits of more spending but governments do have a critical role to play in the face of this kind of crisis: first, to spread the pain as fairly as possible; second, to care for those who are most vulnerable; and, finally, to facilitate the necessary adjustments rather than standing in their way. Given that so many resources (with labour foremost amongst them) tend to be both plentiful and cheap during crises, it probably also makes sense to embark on carefully chosen investment projects with a realistic chance of being profitable .

Trying to return economic activity to pre-crisis levels, however, is definitely not amongst those useful roles. Much of the output gap that many, including Krugman, are so eager to fill is illusory. Boomtime patterns of demand (and the supply capacity that arose to meet it) were heavily shaped by the ceaseless flow of credit, not only in their extent but also in their nature. Today’s patterns are different and, in the absence of rapid credit growth, much smaller. Tomorrow’s are likely to be even more so. Adjusting our productive capacity to these shifts is one reason why the aftermath of credit booms tend to be so painful and drawnout.

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Yesterday, in “A Terrible Ugliness Is Born”, Krugman took Liz Alderman’s portrait of Ireland for the NY Times as the departure point for a fresh assault on the “apostles”.

It’s been a constant theme of his that much of the rationale for austerity rests on the presumption that markets must be appeased, that a failure to do so will bring things tumbling down. Two things, in his view, argue strongly against this idea. First, the continuing ability of high deficit countries like the US and the UK to borrow at historically low rates suggests the bond vigilantes aren’t exactly saddled up and ready to go. Second, he maintains that those countries who have signed up for the bread and water regime, like Ireland and more recently Greece, have been treated no more kindly by the markets than those who, like Spain, have been more reluctant.

The first, I think, is a bit of a furphy. CDO’s could also be funded at relative rock bottom rates prior to the crunch, and it’s only a couple of years since CDS spreads for Greece and its unhappy compañeros were cruising along at not much over 50 basis points. This despite (to take Greece as an example) a long, largely uninterrupted period of current account deficits averaging over 10% of GDP, government deficits averaging about 5% of GDP and negative net national savings (that’s before net investment is taken into account). Definitely not good in other words. So a serious crisis in Greece was already baked in for many years but ignored by the market. Truth is, when it comes to the markets facts don’t matter until suddenly they do. Who’s to say something similar isn’t happening with the US and the UK?

As for the second, that austerity isn’t bringing any benefits to its practitioners, here Krugman is either being worryingly simplistic or letting a desire for rhetorical effect push the inconvenient bits (aka reality) aside.

He has, for example, made much of the fact (most recently here a couple of days ago) that Spain’s risk spreads are less than Ireland’s. As it happens, that difference is narrowing with Spain now only one basis point below Ireland. More importantly, however, comparing CDS spreads on two countries without considering their fundamentals makes no more sense than doing the same thing for two companies.

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Ireland is certainly no specialty of mine but I did run across an intriguing piece from Professor Morgan Kelly of University College, Dublin. He divides the 15 year period of growth from 1991 to 2006 into two distinct periods: the 1990s with increased competitiveness, rising employment and an extraordinary growth in exports; and the first half of the last decade when things morphed into a frenzied boom in construction and (of course) an equally astonishing growth in credit. A couple of charts from his article illustrate the extent and some of the consequences of the latter.

In 10 years, bank lending to households and non-financial corporations more than tripled, from about 60% of GNP to over 200%. Most of it went to finance mortgages and development activity. The results weren’t pretty.

Amongst the many figures and comparisons provided by Kelly, one stood out: “By 2007, Ireland was building half as many houses as Britain, which has 14 times its population.”

When the bubble finally burst, Ireland was left with an extraordinarily overextended financial system (even by the rich standards of the last decade) and a very tough decision. Should the government back the banks all the way or let bank creditors (other than depositors) suffer the consequences of their folly? Unfortunately, it chose the former.

With total bank assets in Ireland equal to almost ten times GDP (about 40% of them international in scope)[1] this was a momentous, and possibly fatal, choice. I’d wager that most of the concerns swirling around Ireland, the sort that keep its risk spread as high as it is, stem from this sword now hanging over its head. Kelly sums it up in his closing paragraphs:

“Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.

Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap.”[2]

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Spain also had a boom, both in real estate and in credit, but in relative terms, at least compared to Ireland, it was a piker. At the end of 2008 its banking system had liabilities equal to about three times GDP, high enough to be sure, but well within the current exaggerated range (here in Australia, by way of comparison, the ratio is just a touch over two).

At any rate, I’m sure you get my point. Ireland is in the doghouse for some highly idiosyncratic reasons, ones that as Kelly suggested above, it could change. Until and if it does, comparisons such as those made by Krugman are of little or no value. Even less, if that’s possible, than would normally be the case.

Nor are his comments about Greece’s failure to be rewarded for its new-found parsimony much more relevant or useful. Until I looked at its national accounts, I had no idea just how badly Greece had run off the rails. As suggested by the few numbers quoted earlier, it truly is an economic basket case. Its austerity measures, however well meant, are almost certainly both too late and too little. Mostly too late.

Truth is, it’s probably not politically feasible for Greece to work its way out of this mess and so, barring some miracle, I don’t see how a restructuring of its debt can be avoided. The market seems to be coming to a similar conclusion; the 5 year risk premium closed last night at 10% over equivalent duration US Treasuries. Higher, for the first time, than the panicky levels hit prior to the EU/IMF bailout package in early May.

These are slow motion tragedies, albeit in part self-inflicted ones, and we’re likely to see many more in coming years. How best to respond  is no straightforward matter and all of us, I think, if we’re honest, know that we’re only feeling our way forward. Although my framework is very different to Krugman’s, I often get real value from his writings as well as thoroughly enjoying them. Providing, that is, they don’t slip across into propaganda.

Of late, it’s felt at times as if he’s been flirting with that boundary.


1 Countries with disproportionately large banking systems face very real dangers, most vividly illustrated by Iceland’s implosion. When they have their own currency (like Switzerland, the UK and of course Iceland) those dangers are heightened. William Buiter has written some interesting articles on this topic, for example here and here.

2 If only. The failure by authorities around the world to force bank creditors to absorb their rightful share of losses, whether through haircuts or the conversion of some of the debt to equity, was in my view the single most critical error made during the crisis. It was a classic case of privatised profits and socialised losses and quite apart from the ongoing burden to taxpayers, the decision gravely undermined public confidence in the fairness of government decisions. The long-term cost may well, in some cases, prove critical.