Scott Sumner  

Macroeconomics in small economies

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Like many American economists, I've learned macroeconomics from an American perspective. But America is a very unusual country. For instance, US RGDP growth has averaged about 3% for the past 120 years, if not more. Most business cycles are fairly small, partly reflecting the fact that our economy is well diversified. If Nevada is in recession, Massachusetts may be growing, or vice versa.

Other economies don't seem to adhere as closely to a stable trend line. Japan did very poorly in the 1940s, then raced ahead for decades, and has seen little growth since the early 1990s. Even smaller economies such as Latvia, Estonia, Iceland and Greece have seen spectacular booms followed by huge busts.

In the following quotation, I believe Paul Krugman is wrongly applying American-style macro thinking to the Greek case:

But doesn't the ultimate cause lie in wild irresponsibility on the part of the Greek government? I've been looking back at the numbers, readily available from the IMF, and what strikes me is how relatively mild Greek fiscal problems looked on the eve of crisis.

In 2007, Greece had public debt of slightly more than 100 percent of GDP -- high, but not out of line with levels that many countries including, for example, the UK have carried for decades and even generations at a stretch. It had a budget deficit of about 7 percent of GDP. If we think that normal times involve 2 percent growth and 2 percent inflation, a deficit of 4 percent of GDP would be consistent with a stable debt/GDP ratio; so the fiscal gap was around 3 points, not trivial but hardly something that should have been impossible to close.

America would be able to support a public debt equal to 100% of GDP. But unlike Krugman, I believe the Greek situation in 2007 was "wildly irresponsible." Greece needed to run budget surpluses during the boom years, so that it would have the resources to do fiscal stimulus during a depression. Instead they ran a very large budget deficit during the boom period.

By the way, notice that Krugman simply uses the actual budget deficit, not the cyclically adjusted (structural) deficit, which presumably was even worse. In contrast, when economies are depressed he tends to use the cyclical adjusted deficit, which makes policy look more contractionary than the raw figures would suggest. Here is his excuse:

Now, the IMF says that the structural deficit was much larger -- but this reflects its estimate that the Greek economy was operating 10 percent above capacity, which I don't believe for a minute. (The problem here is the way standard methods for estimating potential output cause any large slump to propagate back into a reinterpretation of history, interpreting the past as an unsustainable boom.)
I would certainly not believe a 10% over capacity estimate for the US economy in 2007, but I don't find it all that implausible for Greece. Suppose your economy is sucking in lots of foreign workers for a real estate boom. The boom ends and the foreign workers leave. Now your "natural rate of output" is lower, as you have less labor. The outflow of Mexican labor after 2007 was not enough to cause a big drop in the US natural rate, but in a smaller economy like Greece, or Nevada, or Dubai, that sort of shock to capacity output could be much more significant.

In the 1999-2000 boom the US government did run a budget surplus, and I believe Krugman supported that policy. He once suggested that President Bush made a mistake by cutting taxes and putting us back into a structural deficit. I'd argue the same applies to Greece (and Iceland, Estonia, etc.). Countries with those sorts of wild swings between boom and bust need to run surpluses during the good years. Because Greece did not do so, it is now forced to beg for loans from others. Its creditors know that it is unlikely to be able to repay those loans, and not surprisingly are reluctant to grant even more loans without some pretty strict conditions attached.

I recall that Australia went into the Global Financial Crisis with a net debt of less than 10% of GDP. If Greece had done the same it would be far better off today. (Sometimes the VSPs worries about public debt are actually true.)

I do agree with Krugman's conclusion:

The euro straitjacket, plus inadequately expansionary monetary policy within the eurozone, are the obvious culprits. But that, surely, is the deep question here. If Europe as currently organized can turn medium-sized fiscal failings into this kind of nightmare, the system is fundamentally unworkable.
Yes, but for better or worse the Europeans are strongly committed to the euro. Even the Greek public is strongly committed. So Europe needs to make the system work better. And that means radical reductions in debt, back to levels where there is room to do fiscal stimulus during deep downturns. And that also means a move towards much more neoliberal policies, to make labor markets more flexible. And that also means the ECB needs to switch to a policy that stabilizes aggregate demand for the entire eurozone, such as NGDP targeting. All of these things need to be done, and if they are done then the euro may be able to work tolerably well. But I'm not optimistic that these things will be done, which is why I still think the euro is a bad idea.

What about fiscal union? That would require political union, turning the eurozone into a single country. It's not likely to happen and I believe it would be unwise.

Comments and Sharing

COMMENTS (14 to date)
Lars Christensen writes:


Both you and I strongly believe in the judgement of the markets so why is it that the Greek bond market didn't seem to worry in 2007 if fiscal policy was "wildly irresponsible."?

I do think that Greek fiscal policy was unsustainable, but the key problem was the massive collapse in Greek NGDP. If had had a flexible exchange rate the value of the Dracma would have been halved in value and there would have been no debt crisis. Fiscal challenges? yes, but the sharp rise in Greek public debt ratios is driven by the collapse of NGDP.

Furthermore, it would be noted the Greek government actually has cut public employment by 25% and Greece has the biggest primary surplus (5% of GDP) of any country in the euro zone.

But one issue that we haven't really focus on is the massive moral hazard problem created due to the ECB collateral rules prior to the crisis. Hence, according to the rules Greek govies were essentially as good collateral as e.g. Dutch bonds. I believe that that was a big driver of the imbalances within the euro zone.

Carl writes:
Yes, but for better or worse the Europeans are strongly committed to the euro.

European politicians, sure. But not this European.

Mikk Salu writes:

I am not an economist, but can you explain unsustainable part a bit. I mean, in 2007 Greece interest payments were 10,7 billion or 4,7% of GDP. In 2014 it was 6,6 billion, actually even lower because interest payments to ECB an other central banks are counted only formally, they do not have to pay these - it means 2,6% of GDP. I know that their debt to GDP is much higher, but if their yearly interest payments are considerably lower, how can it be that in 2007 4,7% of GDP was sustainable, but 2,6% in 2014 is not sustainable?

Lars Christensen, I do not believe that Greece has cut public employment by 25%. OECD said few years ago (it was general labour market report, not about crisis), that they do not know what is public employment number in Greece beacause Greece doesnt know. I have seen later Greece officials and Troika experts saying similar things. I think they have cut, but not even close to 25%.

bill writes:

Krugman is flexible. Here he (correctly in my opinion) says "inadequately expansionary monetary policy". But usually he goes on and on about how ineffective monetary is at the ZLB and how Europe has been at the ZLB since 2008 even when it was raising rates in 2011.

mico writes:

If Greece's debt was no big deal and could have been repaid then it could have continued to borrow from the international bond market, and not have had to listen to the IMF or EU and their conditions. The IMF and EU offered conditions in exchange for loans with below market interest. If Greece had a better deal elsewhere, they would have taken it.

Krugman is not an idiot and he is not a liar. He knows exactly how and why he is misleading his readers while staying technically on the right side of truth and he is doing it deliberately.


For what it is worth I agree with Krugman and not you that if the Euro is considered sacred then the EU must be willing and able to do otherwise unnecessary fiscal policy, since the Euro takes monetary policy off the table. In order to stop countries running structural deficits in the boom times and then drawing on central funds in the bad times, as Greece has done, that means that the EU must control the finances of member states, which is essentially the end of national sovereignty. The bottom line is that Europeans (at least most of the mainland) are wedded to two mutual incompatible goals: supernational unification and popular sovereignty. If they are willing to accept Europe as a more or less unitary nation-state than they can make it work. Otherwise, they should unravel the Euro.

Scott Sumner writes:

Lars, I don't think the markets anticipated the Global Financial Crisis, and in addition Greece was lying about the size of its deficits, so the market didn't really know what was going on. But I think we agree that the fall in NGDP was the proximate cause of the Greek crisis. Even so, if you are going to join a currency union you need to make sure that you can survive a big fall in NGDP, just as if you build a house on the coast of Florida you need to have a high enough sea wall to protect you during a hurricane.

I don't agree with your claim that Greece has a primary surplus.

The biggest moral hazard problem is political. If they bail out Syriza, why wouldn't a rational Spanish voter vote for Podemos, and demand the same deal?

Carl, I wish there were more like you.

Mikk, I can't answer that. I've always been skeptical of the claim that Greece cannot pay its debts. If a 100% debt at high interest rates is easily serviceable, why not a 177% of GDP debt at low rates? I wish I could answer that question, but I cannot.

Bill, I've made the same complaint about 2011.

mico, You may be right that monetary union implies political union. Time will tell. I freely concede that I might be wrong. As I've said many times, I'd prefer each country had its own currency.

Jerry writes:

I have a question concerning the United States Federal debt/GDP ratios. I have been seeing figuring stating $13.6 trillion, but I thought it was $18.2+ trillion and counting. What are they referring to? Wikipedia also is showing numbers that seem incorrect.

If you could show me the errors of my thinking I would appreciate it.


lysseas writes:

Hi everyone,
A few facts for (and from) Greece:
1) The cut in spending for public employees has indeed been spectacular. The thing is... that a part was from pay cuts, a very small part from lay-offs, and a big part was due to big numbers of employees going to early pension (true, without most of them being replaced), thus still being paid by the state budget as pensioners.
2) There was an actual primary surplus in 2013 and 2014, but it has definitely been turned into a deficit for 2015. Keep in mind that we are talking about EUROSTAT rules (EDP result). I can elaborate if needed.
3) Austerity was real and harsh, but implementation of structural reforms has been pathetic - too many interest groups and weak leadership. Also, austerity was mainly focused on the small healthy part of the small private sector and on some honest tax-payers paying taxes by making their savings disappear.
4) I agree with Dr Sumner's opinion that monetary policy has been a big part of the problem, but the structural is definitely the main reason.
5) In spite of everything, prospects were looking slightly up for the economy (after a long decline) in mid-2014, but even the prospect of the early elections of January and of Syriza winning, reversed everything violently (a lot of people stopped paying taxes and mortgages because of promises of "write-offs"...)

lysseas writes:

p.s. ...and those cold-hearted Troika experts made the government finally count the public employees a few years ago and set up a mechanism to keep track, so that's OK now...

Jose Romeu Robazzi writes:

Europe has to change the structure of the banking sector, they should allow for the existence of true continental banks. Some of the demand for Greek bonds bak then came from the structural demand from the local banks. I am not an specialist, but it seems to me that greek banks had (and still have) a regulatory incentive to by sovereign Greek bonds.

JD writes:

Hi Jerry,

It depends on the source of the numbers, but the answer is likely either:

1) The US has differentiates between total debt and debt held by the public. The total debt includes treasuries in the government trust funds (e.g. bonds in the social security trust fund). The different values represent two separate measures of the debt.

2) $13.6 trillion seems a bit higher than the debt currently held by the public, so it could simply represent a stale value for the total debt (believe it was about $13.6 trillion back in 2010).

Gordon writes:

I'm no economist so I reserve the right to be horribly wrong. But was the issue the amount of debt that Greece was accumulating or was the issue the purposes to which it put the money? The Greek government pumped up employment and wages amongst government workers and at state owned enterprises. All of this contributed to a very heavy current account deficit. Here are the numbers for Greece's current account deficits from 2007 to 2012 expressed in U.S. billion dollars (taken from the World Bank website):

2007 -44.59
2008 -51.31
2009 -35.91
2010 -30.28
2011 -28.58
2012 -6.17

In a common currency area, that represents a massive amount of deflationary pressure.

J.V. Dubois writes:

This is a very good analysis but it also omits another large elephant in the room - private debts. There are European countries that had relatively good fiscal situation - Ireland with debt/gdp in 20% area, Spain in 40% area etc.

What I want to say is that low deficit is not a proxy for good situation. Take Russia as an example. Even though it is a very large country with huge population its economy is diversified and it has huge supply side problems starting from structure of economy to dysfunctional institutions and corruption.

Russia also has low government debt in 10s of percentage points. However everything else is set up against it. Debt being held in foreign currency while local currency is quickly detoriating. High private indebtedness (in foreign currency) leading into potential financial crisis. Huge increases in government needs especially to finance ever growing army.

So I agree with you - for Greece supply side reform is key. On the other hand it would be dangerous to equate good fiscal situation to a low-risk environment especially for countries that you mentioned. When things turn bad they go down really fast. It can take just a few years or few bank bailouts to squander government surpluses that were saved for decades. If in the midst of the crisis you have one or two populist governments things can get real bad for a long time.

J.V. Dubois writes:

PS: just to correct a mistake, I meant to say that Russian economy is NOT diversified.

Also on top of why fiscal situation is not the only thing there was a good article some time ago here:

What is interesting is to see how were the boom years used. All PIGS countries had huge current account deficits before the crisis. However what is interesting is that these surpluses were much spent on capital formation. In countries like Ireland the capital formation during 2001-2007 incresed by 30% compared to situation during nineties.

Under these circumstances it would be a huge problem if situation stopped, but it got worse and the investment bonanza actually reversed during crisis. So unless you are a large and diversified country you will have a problem coping with such sudden changes. Responsible fiscal policy can help here but only as a buffer.

Unless of course fiscal policy was used to support overal growth such as building necessary new infrastructure (roads, schools, highway, internet infrastrucutre etc.). Then it is much harder to say what was and what was not responsible fiscal policy.

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