David R. Henderson  

Fiscal Policy: A Counterexample for Krugman

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Blame Canada for contradicting Krugman.

Paul Krugman writes:

And bear this in mind: no country has driven itself into a debt crisis with stimulus -- nor has any country with significant debt regained investor confidence through austerity.

Actually, the last clause is false. The Canadian government, under the Liberal Party, turned around its serious debt crisis between 1995 and 2006. As I wrote in "Canada's Budget Triumph":
The result of years of cuts in government spending was that, as a percent of GDP, federal spending on programs fell from a high of 17.5 percent in 1992-93 to 11.3 percent in 2000-01.

The Canadian government had lost its AAA rating on its government debt in 1992; after 7 years of austerity, from 1995 to 2002, it regained its AAA rating.

HT to Robert Murphy.


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CATEGORIES: Fiscal Policy



COMMENTS (19 to date)
David Beckworth writes:

David,

The fiscal austerity only worked because monetary policy offset the contractionary drag from it with monetary stimulus. In other words, fiscal retrenchment works if the monetary authority is doing a good job stabilizing the growth of nominal spending. The Bank of Canada dropped interest about 5 percentage points over the 1995-2000 period to do just that.

See Stephen Gordon's post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/10/canadas-budget-triumph.html

Also see this related piece: http://www.tnr.com/article/economy/97013/obama-federal-reserve-inflation-loose-money

Jonathon Hunt writes:

And Krugman would probably respond with two words: Liquidity Trap.

David R. Henderson writes:

@David Beckworth,
That could be. It doesn’t take away from my point that Krugman’s statement is incorrect.

Herbert Walter writes:

Not only Canada.

Consider Denmark, Sweden, Finland in the 1990s. There are several more examples of cutting spending while returning to growth

NickL writes:

Odd for Krugman to write about China potentially breaking one day later.

He has the facts on China slightly wrong. Shadow lending has contributed to the recent growth in credit but the primary reason for the over-investment in fixed assets, including real estate, has been a massive surge (30+% of GDP) in bank lending over the last 2.5 years. This bank lending was directed by the government, which controls the major banks, as a response to the 2008 global crisis.

China can soon prove Krugman wrong and be the first country (in his books) to have entered a debt crisis through aggressive stimulus.

[URL fixed--changed to NYTimes permalink.--Econlib Ed.]

david writes:

Why "perhaps"? Do you really think that, had the Bank of Canada not pursued an expansionary policy, Canada would have regained investor confidence through fiscal contraction?

Normally we have ceteris paribus and all that...

CC writes:

So your one exception takes place in a single country during the biggest worldwide economic boom in our lifetimes? Sounds like the exception that proves the rule to me.

David R. Henderson writes:

@david,
No one above, other than you, said “perhaps.” So I don’t know whom or what you’re addressing. Please clarify.
@CC,
My one counterexample to Krugman’s statement--which allowed for no exceptions--happens to be the case I worked on. That’s what I know best. There could be many more counterexamples.

Jeff writes:

Sayeth Krugman:

It is indeed frustrating that after three years in which Keynesian predictions have been spectacularly correct, pundits insist on reading the evidence as a rejection of Keynes.

I stopped reading at that point. I could not be any less interested in the thoughts or opinions of a person who's this detached from reality.

Brian Moore writes:

The first half of his statement is pretty funny too -- "stimulus has never driven a country into a debt crisis," but certainly all the spending beforehand has.

Because he says "stimulus" instead of "government spending" he protects himself against making a ludicrous claim. But he's left with a meaningless statement -- of course "stimulus" that occurs as a suggested cure to a recession doesn't push the country into a debt crisis, it's a drop in the bucket compared to all the spending (which in retrospect seems like too much, because it was based on inaccurate revenue estimates) from before. It's like saying "of course that last laptop I bought didn't push me into bankruptcy, it was only 1000 dollars, and I owe 100k!"

Lawrence H. White writes:

David Beckworth writes: "The fiscal austerity only worked because monetary policy offset the contractionary drag from it." David B., what makes you think that a budget surplus has a negative effect on real output (or conversely that a deficit stimulates real output)? Do you think that substituting present for future taxes reduces real output? Or do you think that there is a positive spending multiplier?

Lord writes:

A drop in an AAA rating is now a debt crisis? Seriously??! As Paul has pointed out, their solution was lowering the exchange rate and gaining exports, something the countries in Europe can't do and that all countries can't do as a whole.

Lars P writes:

Sweden had a similar history, around 1993-2003, and also weathered the recent sky falling fairly easily.

It strikes me that those who say that austerity hasn't worked haven't given it nearly enough time. It has only been tried for 1-2 years at the very most. These things take upwards of a decade to play out.

Bob Murphy writes:

I declare David R. Henderson the winner of this thread... The only possible objection is the one "Lord" brings up, that Krugman might argue that Canada wasn't actually suffering from a "debt crisis" and so by definition couldn't have recovered from it, through austerity.

David Beckworth, like Larry White I found your reply exasperating but for a slightly different reason. Look at what you're doing here: Krugman says, "Austerity never rescued a government in fiscal crisis." David points to a government that had its bond rating cut, then it slashed spending, and had its AAA rating restored. You complain that this doesn't really count, because the central bank lowered interest rates.

So, now the onus is on us to find a country that:

(a) Had an honest-to-goodness "debt crisis,"

(b) Slashed spending to deal with it,

(c) Ended the debt crisis,

and

(d) Didn't experience a drop in interest rates, as the country emerged from "debt crisis" to being fine?


Do you see why we are being given an impossible task?

To put it another way: Companies with a AAA rating can borrow at lower interest rates than companies with a BBB rating. Is that because of "monetary policy"? I mean after all, if the central bank started buying up BBB bonds and short-selling AAA company bonds, we could probably reverse that typical interest rate pattern.

Bob Murphy writes:

Oops I take my concession back--"Lord," go re-read Krugman's quote. His challenge wasn't to find a country in a "debt crisis" that emerged through austerity. No, the "debt crisis" referred to stimulus. What Krugman actually said was:

"...nor has any country with significant debt regained investor confidence through austerity."

So yes, the fact that Canada had its AAA taken away, and then restored, shows Krugman is wrong.

I now declare David R. Henderson the undisputed winner of this thread. Carry on.

Jason writes:

The AAA rating is irrelevant, what matters is whether austerity can reduce interest rates on long term government debt so that's what we should be looking at. Really all you need to believe is that austerity can actually raise fiscal surplus, which is entirely reasonable, especially long-term projections of the NPV of surpluses. Higher fiscal surplus will surely reduce default probabilities.

Lord writes:

It wasn't austerity that did it but a lower exchange rate and larger exports.

RDGP writes:

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Desolation Jones writes:

As we learned from the US's recent downgrade, ratings are not necessarily important to investor confidence. Through various krugman readings, you can pretty much equate investor confidence with interest rates. A cursory glance at at Canadian interest rates on bonds show no obvious sign that they were affected by the downgrade.

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