Estonia v Krugman: It may work in practice, but it will never work in theory

Last Friday I attended a lunch at the Centre for Policy Studies with Jürgen Ligi, Minister of Finance for Estonia.

This was of particular interest to me as Estonia’s approach to cutting its budget deficit and coping with austerity had been cited by Jon Moulton on the Newsnight programme in which he was appearing with Paul Krugman, the Nobel prize winner and economist who writes for the New York Times.

Krugman was dismissive of the Estonian example both on and off the air. Krugman has criticised the Estonian model on the grounds that output has still not reached the level of the peak of the boom: “So, a terrible — Depression-level — slump, followed by a significant but still incomplete recovery. Better than no recovery at all, obviously — but this is what passes for economic triumph?”. As Estonian President Toomas Hendrik Ilves tweeted: “Let's write about something we know nothing about & be smug, overbearing & patronizing” And: “Guess a Nobel in trade means you can pontificate on fiscal matters & declare my country a "wasteland".”

The facts are that when the financial crisis broke, the IMF forecast that Estonia was on course for a budget deficit of more than 10% of GDP in 2009. But the austerity programme ensured that it never exceeded 3% of GDP and was back in surplus by 2010. Unemployment which peaked at 19% is now back to around the European average of 10% (compare and contrast Greece or Spain). Real GDP is still about 8% below its 2007 peak.

I thought that Jürgen Ligi made some interesting points at the lunch about the Estonian experience including:

1. Economic activity has not yet recovered to the level preceding the period of austerity, but that previous level of economic activity was illusory-fuelled by a period of excessive lending and borrowing to spend which reached its peak in 2004-07. This is a vital and often overlooked point.

This puts into sharp relief Ed Balls continual sniping about the poor performance of the UK economy. It is inevitable. The previous highs from which it is struggling to make any progress were illusory.

At a more micro level, there are a number of managers in financial services businesses in particular who may have to realise that aiming to restore profitability to the level before the financial crisis may be equally impossible for the foreseeable future.

2. Two thirds of the budgetary adjustment came from spending cuts, one third from tax increases.

3. The tax regime adopted was a simple one with flat rate income tax.

4. There were no exceptions to the necessary policy measures – whether taxes or spending cuts. VAT was raised from 18-20%, and imposed on food.

5. Everyone shared in the hardship, including politicians and civil servants. They didn’t just mouth platitudes about all being in it together. The Minister of Finance took a 27% pay cut.

6. Many people say that budgetary adjustment of the sort implemented in Estonia is impossible in a democracy because turkeys (the recipients of state aid) do not vote for Christmas (or Thanksgiving) as Mitt Romney has recently pointed out to his cost. So how did the Estonian government manage this feat? The Minister had an answer: The people of Estonia had experienced communism under Russian control and had no desire to go back to it. In contrast, the countries of southern Europe (and France) may have that ahead of them.

Comments

[JG]

Thanks for bringing this to our attention. Your rational perspective is appreciated. It does seem odd that Mr Krugman continues to command such platforms, perhaps anyone is better than a prophet...

For anyone interested to read further, the full case study can be found, with a free to download PDF, at the CPS website (no affiliation): http://www.cps.org.uk/publications/reports/estonia-a-case-study/

[Nick]

"Krugman was dismissive of the Estonian example both on and off the air. Krugman has criticised the Estonian model on the grounds that output has still not reached the level of the peak of the boom: “So, a terrible — Depression-level — slump, followed by a significant but still incomplete recovery."

Don't these "economic experts" realise that GDP growth pumped up on funny money is not real. The "peak of the boom" is not real - if it had been real sustainable GDP it would not have bust. So how can one talk of getting back to the peak of the boom when the economy was never really there in the first place.

No hope of serious spending cuts in the UK. Just more serious waste and incompetence whilst the political elite argue the toss about the best (or should that be worst) way to spend the taxpayers money (as well as how to get more off it).

[Howard des Forges]

Sadly, nobody in government or opposition is listening or thinking with an open mind. They are too busy with gestures that attempt to defy economic gravity. Who on earth can help us?

[Terry Smith]

Howard de Forges: As ever I think we need to help ourselves. Through whatever means- the Press, blogs, TV and the polls, we need to explain to the political cabal which is in charge that we will force a change in policy to restore some sanity. I would support anyone who tells the truth about our dire situation and an intention to follow the unpalatable but necessary remedies.

[Nick]

What about an e-petition. There must be at least 100,000 people who would support a parliamentary debate about government spending and how that is financed. Must be possible to frame a petition that seeks a bill that requires any government to run a balanced budget. And sets ground rules for the scale of the budget and the measures to be applied when 'market forces' (or other factors) result in significant deficits. Could include provision to pay down and control the national debt (including any off book debt such as that generated by PPI etc.

- government expenditure cut to 30% of GDP with long term aim of taxes being no more than 30%;
- no overall tax rises, a balanced budget being achieved through spending cuts alone;
- long term aim of no more than 30% of GDP taken in taxes;
- Short term taxes above 30% go to debt reduction;
- budget overruns are dealt with by spending cuts, not tax rises.
- etc.

Should be possible to frame something suitable. Or do we end up arguing the toss about the words in the e-petition?

[Andrew]

Without commenting again on the utility of the Estonian example, I wanted to draw your attention to an Alphaville post in yesterday's FT which addresses directly the first "interesting point" you raised: how "illusory" is the output gap?

In the UK, the paper argues, even after adjusting for "overheating" it may be larger than you think...

http://ftalphaville.ft.com/blog/2012/10/04/1191411/why-the-uk-output-gap-could-be-a-chasm/

[RussH]

Small economies can cut debt as above, just as Sweden and Canada did in the nineties. However if its done on a Europe wide or American wide scale then all that will happen is the banking system will implode.

As far as I can see in a fiat based money system, the supply of money has to increase or it breaks. If we have a very simple economic system with two players and one bank, one deposits a hundred pounds at three percent and one takes out the hundred pounds at six percent, unless new money is issued then the system breaks, as the borrower cannot pay the lender and the bank cannot even pay the interest. So unless the debt is written off or additional money is created it cannot work. Are you advocating writing off large amounts of debt through bankruptcy?

Another question is, why is QE often referred to as "funny money"? as far as I can see, a fiat money system is all make believe anyway, so why is QE worse than any other money in the system?

[Terry Smith]

RussH: The QE money is injected by the government purchasing its own bonds. I think you can see how this can have a corrosive effect if you take it to the extreme: why doesn’t the government do enough QE to pay off all its debt? Because if it did so, or even got close(r) to doing that we should all logically conclude that the money being issued is worthless.

[RussH]

If the City view is that QE renders money worthless and austerity leaving people unable to buy anything as the Banking system will implode then we had better think of something else. What worked in the last depression?, please don't say war, we can do without that!.

[Terry Smith]

RussH: What worked in the last Great Depression? The simple answer is: not a lot. After eight years of Roosevelt’s New Deal, for example, unemployment in America was still 17%. I would look at it this way: what policies were adopted in the Great Depression and do the opposite as they were totally ineffective or worsened the situation. Roosevelt’s New Deal was characterised by increases in taxation, devaluing the currency, an increase in business regulation and the creation of utterly pointless jobs subsidised by the state. I would therefore suggest we try cutting taxes and regulation, and forget about paying people to do pretend jobs with our tax revenues.

[RussH]

Since it wasn't the New Deal or WW2 that was responsible for the post war economic expansion it certainly wasn't low taxes as they were quite high after the war and there was high growth.

As regards to regulation the finance sector has lobbied for and got "light touch" regulation and failed fairly dismally to produce wealth, so no to that as well.

With regards to utterly pointless jobs its not just the public sector, the private sector can manage it as well. HFT is utterly useless for creating wealth and why is the amount of currency trading so many times that necessary to fiance world trade?.

It can be pointed to DARPA, public funding of the internet, CERN the world wide web and the MRC funding the development of monoclonal antibodies which has led to hundreds of billions if not trillions of economic benefit. I do not feel its a case of public/private good or bad, both have their place and both have space for huge improvements in the allocation of the capital they use. I, personally, am fed up of hearing that everything should be privatised/nationalised, we are in an unholy mess and if we stick with prejudiced arguments from two sides that are starting to sound as reasoned as the Taliban we will not get out of it.

[Terry Smith]

RussH: I didn’t say that it wasn’t WW2-you told me I mustn't say it. It wasn’t the New Deal. I think the recovery was generated by a combination of factors. The spend on WW2 which in the USA’s case was a clear net benefit as it did not experience any fighting on US soil (I’m not counting the few Japanese balloon bombs which landed on the west coast or of course Pearl Harbour) and the resulting destruction of its infrastructure. The US was the greatest industrial power and one which entered the war later than the other Allies and so was in a position to maximise the trading advantage from rearmament. That is an important point, the War is often pointed to as the most important factor in recovery purely because of rearmament, but it also led to a revival of American trading with its Allies which had languished during the protectionist years of the Hoover government and the Depression. Plus the Truman administration was not as vehemently anti business and private investment as FDR had been. I agree with you. It is not a case of private investment/spending employment is always good and public sector is bad. The arguments around this are indeed characterised by prejudice and ignorance, which is why I think it is important to study the history of events like the Great Depression in order to obtain evidence about what to do and what not to do. I also agree with you that High Frequency Trading has no useful purpose for markets or society and is in fact dangerous and damages markets in which it operates.

[Andrew]

Ah, the New Deal Revisionist emerges. I suppose I ought to have expected that.

The unemployment rate went from 25% to 17%: the biggest drop in US history (and that doesn't include the 2m+ workers in Emergency Programs who aren't included in the BLS data. (Darby (1975)). Could it have been lower? Yes, but in 1933, there wasn't a consensus on how to tackle such a devastating recession so it wasn't all plain sailing in FDR's Administration: there were setbacks and contradictory policies. (As an avid student of history, I'm sure you'll recall that FDR's re-election campaign included promises of spending *cuts* to assuage debt fears. Of course, the economy slipped back into recession so that plan was thrown out and the second phase of the New Deal was implemented.)

You're correct that, following this phase, the build up to WWII caused even more spending and resulted in full employment.

And those "pretend jobs"? Well, they were only responsible for "[building or renovating] 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields." (Auerback (2008))

"I think it is important to study the history of events like the Great Depression in order to obtain evidence about what to do and what not to do."

I couldn't agree more. And the sooner you start doing that rather than indulging in this revisionist claptrap the better.

[Terry Smith]

‘Claptrap’. Now, now Andrew, I have been polite about your views even when you selected a passage out of the middle of the research on the correlation between the size of state spending and economic growth which was summarising other research and claimed it was the conclusion, which it wasn’t. When something doesn’t work, such as the lack of any discernible economic recovery after the massive stimulus we have had from deficit spending, zero interest rates and four rounds of Quantitative Easing I think it would be wise to contemplate the possibility that these policies are misguided, not that we just need more.

[RussH]

Thanks for replying to my earlier post. So we can agree its not whether we have State investment or Private investment that is important but whether that investment produces a return on that investment. Since resources will be wasted if investment decisions are poor, then it would seem some sort of analysis of why investment decisions have been so poor would be in order, yet this seems hardly discussed. After all public spending will still be a lot of money even if it is cut, so we may as well make the most of what is invested.
As regards QE, we would only know if it did not work if we had an experiment of Britain run without QE but as the recent IMF report said each unit of spending cut cuts between 0.9 and 1.7 units of GDP, if everyone cuts spending together, it is not likely to do anything other than make the recession much worse.

[Andrew]

I fear, Terry, that your magnanimity, while certainly overwhelming, is insufficient to mitigate the fallaciousness of your argument.