David R. Henderson  

Krugman on Canada's Austerity

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Two days ago, I complimented Paul Krugman for a short blog post he did.

Today he came about as close as he ever does to returning the compliment, which is to say, not close at all. But at least he discussed one of my favorite topics, one I have written about and that he criticized indirectly.

Krugman wrote:

For comparison, look at everyone's favorite example of successful austerity, Canada in the 1990s. Canada came in with gross debt of roughly 100 percent of GDP, roughly comparable to Greece on the eve of the financial crisis. It then proceeded to do a pretty big fiscal adjustment -- 6 percent of GDP according to the IMF's measure of the structural balance, which is about a third of what Greece has done but comparable to other European debtors. But unemployment fell steadily. What was Canada's secret?

The answer was, easy money and a large currency depreciation. These offset the drag from austerity, allowing growth to continue.


In other words, he talked about one of my favorite examples of successful austerity, the case of Canada, which I studied here. It's not my absolute favorite. My absolute favorite is one I documented here, in which the U.S. government cut spending, not by a measly 6 percent of GDP, but by about 35 percent of GDP. The result, as President Truman pointed out at the time, contrary to the predictions of Keynesians Paul Samuelson and Gunnar Myrdal, was a postwar economic boom.

Notice, by the way, true to form, Krugman never mentions that almost all of that 6 percent swing took the form of cuts in government spending, not tax increases. Also, notice that in the graph he links to, most of the fall in the Canadian dollar had occurred about the time the big budget cuts began.

Krugman's statement I'm quoting, as Danny Devito's character says in the movie "Other People's Money," should be followed by "Amen, and Amen, and Amen." Because, as DeVito said, what you just heard was a prayer. Or, more exactly, a statement of faith. Austerity had to create a drag. Because that's what his model says. So, of course, the factors that must have been strong enough to offset the drag were monetary policy (which, notice, he doesn't give a link about) and a fall in the value of Canada's dollar. And not just offset the drag, but trigger a boom. (By the way, I do think monetary policy may well have been important, but, as I've noted, Canadian economist Stephen Gordon's way of measuring it--a 500-basis point drop in interest rates--is absurd. David Beckworth measures it the same way as Gordon.)

Krugman never criticized my study directly. Instead, he linked to the criticism by the aforementioned Stephen Gordon, a criticism that I have answered here.


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CATEGORIES: Fiscal Policy




COMMENTS (8 to date)
Bob Murphy writes:

Good stuff David, but let me push harder. I think the Canadian story of the 1990s is the *exact opposite* of what Krugman (and the Market Monetarists) need, for their rival narrative to work. For true wonks who want to see my case, see this post and this post.

Mr. Econotarian writes:

From the study The design of fiscal adjustments looking at 21 OECD countries from 1970 to 2010:

Our results can be summarized as follows: expenditure based adjustments are those which are more likely to lead to a permanent reduction in the debt over GDP ratio. In addition, they are associated with smaller recessions than tax based ones or no recessions at all. The component of private demand which seem to react more positively to an expenditure based adjustment is private investment. Cuts in current spending have smaller or no effect on output than cuts in public investments. The small downturns caused by expenditure based adjustments can be eliminated making the adjustment expansionary even on impact, if the policy package include pro growth polices like labor and goods market liberalization. Monetary policy has the standard effect on output, but it does not seem to play a role in differentiating the effects of tax based versus expenditure based adjustments.
Mr. Econotarian writes:

See this Figure from the Bank of Canada, it seems to me that the inflation rate in Canada dropped from 4% during the 1980s to about 1% during the 1990s. Clearly if money was "easy", it wasn't having any effect on inflation...

I can only find data on Canadian M2 growth starting in 1994, but it does not appear to be significantly different than that of the US, except that Canadian M2 contracted from 1997-1999.

I can agree that the Bank of Canada rate dropped in 1990 and M2/GDP briefly spiked, but then fell.

The US Fed Rate dropped from 1990-1993 as well, and I suspect many countries in the recession dropped their rates.

Regardless, someone has to explain why the Euro monetary situation is good for Germany but bad for Greece. Also someone has to explain why Ireland left its bailout, and now has an unemployment rate at the EU average, whereas Greece has not left its bailout...of course we know the difference in Economic Freedom and Corruption ratings between Ireland and Greece, which I suspect are more explanatory.

David R. Henderson writes:

@Bob Murphy,
Good pieces. The one major disagreement I have is on the determinants of interest rates. It’s hard to believe that in a global capital market, shifts in the supply or demand for loanable funds in a small country could have that big an effect on interest rates.
@Mr. Econotarian,
Thanks on both.

John Hayes writes:

Bob, when I look at the data you reference it looks like the BoC is executing a policy of NGDPLT at 5%. Not coincidentally the Fed was also running NGDPLT at 5% as the two economies were more tightly linked through NAFTA. That's consistent with monetary offset, but it's not the whole story.

Through that decade Canada also reduced it's natural rate of unemployment and that was through real policy changes both major and minor. The major change was NAFTA and moving to a broad consumption tax model. Minor changes included greatly relaxing outgoing foreign investments, privatizing most "non-welfare" government services, creating free-trade among provinces, restricting social insurance and closing most maritime fishing (which eliminated a lot of martime "unemployment" among seasonal fishermen, I think they mostly became ice road truckers).

The most subtle structural change was many laws were rewritten to remove CPI relative values and this made the BoC much more powerful. Inflation lowers government benefits and increases tax rates because the nominal brackets remain fixed. So if the government does nothing and there's a small amount of inflation, the budget will balance.

Devaluation of the currency helped but I would suspect that was less a deliberate scheme and more that the Loonie has strong petro-currency tendencies. Almost all commodity prices through the 90s were low.

The lesson here shouldn't be about the quantity of government spending. If that were the only issue, then we wouldn't need micro-economists. Eliminating incentive distorting policies matters too.

Jon Murphy writes:

Austerity had to create a drag. Because that's what his model says.

I've a question regarding the above quote. Reading this, it seems to me that you think austerity doesn't necessarily create a drag on the economy (if I misunderstand you, please correct me). However, isn't it possible (and I'd argue probable) that, in the short run, austerity would cause a drag? In the short run, as a government cuts spending, the beneficiaries of that spending would now have lower income and spend less. If they are corporations, they could even do layoffs. Wouldn't that have a negative affect?

To be clear, I am not arguing against cutting government spending. I'm about as laissez-faire as they come. I'm just thinking that, in the short term, there would be some pain.

David R. Henderson writes:

@Jon Murphy,
Reading this, it seems to me that you think austerity doesn't necessarily create a drag on the economy (if I misunderstand you, please correct me).
Correct, Jon. I don’t think it necessarily creates a drag. It depends on which government spending is cut.
However, isn't it possible (and I'd argue probable) that, in the short run, austerity would cause a drag?
Possible? Yes. Probable? Depends on the cuts.
In the short run, as a government cuts spending, the beneficiaries of that spending would now have lower income and spend less. If they are corporations, they could even do layoffs. Wouldn't that have a negative [e]ffect?
Yes.
But now consider two hypothetical cuts that would help create a boom. The first is ending the drug war. Police resources would not be needed as much. The labor force would be greater and there would be more productivity. Would police be worse off? Quite likely. But the labor force increase from people getting jobs rather than going to prison could easily outweigh that.
The second hypothetical cut is not just hypothetical, as John Hayes gets at above and as I talk about at length in my Mercatus study: requiring longer periods of employment before one can qualify for unemployment insurance, and shortening the time for which you can receive it. I think that is likely to increase output, even in the short run.

Jon Murphy writes:

Thank you for your response. Reading your comments, I think we are largely in agreement. I may quibble with the Drug War example, but it would be just that, and it'd be mainly over the timing of the "short-run" so it's not really an objection.

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