Monday, August 30, 2010

Why German Leaders Aren't Sado-Masochistic Lunatics, or, Why Krugman Is Either Wrong or Irrelevant

. Monday, August 30, 2010

All of the debate over Germany has focused on stimulus vs. austerity, which has been recast as an ideological battle of technocratic purity: Keynes vs. not-Keynes. I covered a few of these bases here, and Tyler Cowen quoted and extended them here. Let's try to think of it in another way. Suppose for a second that Krugman and his camp has the economics completely correct. Germany and other leading states should not be even considering fiscal retrenchment at the moment, nor should they be encouraging any of the sort from smaller states like Spain and Ireland. Instead they should be doing the opposite, by engaging in a large ramp-up stimulus program. Let's assume that this is, as Krugman says, simple and basic economics, easily understood by anyone who's passed Econ 101 or taken a cursory look at economic history.

For this to be the case, German policymakers and officials at the IMF and elsewhere (the "Pain Caucus") are so worried about some mystical beings ("Invisible Bond Vigilantes") that they genuflect to gain approval from other mystical beings ("Confidence Fairies"). A few prophetic voices in the wilderness ("The Ancient and Hermetic Order of the Shrill") scream into the void, to no avail. Krugman is obviously a very public figure, so it is unlikely that policymakers are ignorant of his arguments. The only conclusion is that these policymakers are sado-masochists, insane, or both. I believe this is Krugman's default position.

How helpful is it to assume, as a starting point, that leaders are masochistic lunatics? Not very, in my view. There's a lot of political science theory and research dedicated to the idea that politicians are office-seeking, voters are sensitive to the state of the economy, and therefore sado-masochistic lunatics have a very difficult time controlling policy. So even if Krugman is completely correct about the economics, it doesn't really matter. There must be something else going on, so even if correct his analysis would appear to be irrelevant.

At the start of the crisis the Obama administration pushed European governments hard to enact strong stimulus packages to kick-start their economies. The Obama administration worried that if they did not, that much of the American stimulus spending would be "leaky", i.e. would stimulate other countries' export industries, but not domestic industries. They also worried that American exporters would suffer if demand in other countries remained low. Encouraging other countries to enact stimulus, then, was really about encouraging other countries to buy more goods from the U.S. while U.S. consumers bought domestically. The goal was to boost domestic (American) employment.

This ploy is obviously transparent, and Germany responded almost immediately by saying that they felt their "automatic stabilizers" (things like unemployment insurance) were sufficient stimuli. At the same time, Germany was beginning to realize that they were going to have to spend quite a lot of money to rescue Greece and potentially other southern European economies from Quite-Visible Bond Vigilantes. As you'd expect, bailing out profligate countries during a recession was very unpopular domestically, so the pound of flesh the Germans extracted in return was austerity in debtor countries, and tougher new fiscal rules for the E.U. to prevent a similar outcome from recurring. If Germany ran large deficits by engaging in ramp-up stimulus spending, it would under-cut their own Euro-wide debt-reducing initiative, and might push the economic and monetary union to the brink of collapse.

But Germany's automatic stabilizers were real. The result was that Germany largely engaged in neither ramp-up stimulus nor austerity. Ryan Avent has a good post about this, in which he links to this interactive Brookings map showing which countries did how much stimulus. Germany did much more than France, Italy, or the U.K., and their proposed budget cuts for 2010 and 2011 are the lowest in the eurozone. As Avent concludes, "This doesn't mean that stimulus is the key to German success. But Germany is absolutely not an example of strong growth despite austerity."

In other words, Germany has taken a measured approach: let their stabilizers run their course, but don't blow a huge hole in the budget at a time when they are insisting the rest of the E.U. get their fiscal house in order. Let the recovery come from exporting sectors and productivity gains rather than ephemeral short-run consumption. The Germans are balancing short-run political incentives (a fairly quick economic recovery) with longer-run goals (maintain a strong, stable economic and monetary union). Not only is this strategy not masochistic or insane, it is actually pretty savvy. It's also Germany's only hope for securing the long-run health of the economic and monetary union along with the domestic economy. Maybe the Obama administration would like to see more, but that's hardly Germany's problem, is it?

The takeaway here is that even if Krugman is completely right about the economics, he is wrong about the political economy. This makes his analysis irrelevant at best, completely wrong at worst. I guess I'll let him decide which.


Why German Leaders Aren't Sado-Masochistic Lunatics, or, Why Krugman Is Either Wrong or Irrelevant




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