Paul Krugman's Blind Spot

Sorry, but the New York Times' star columnist just doesn’t understand Europe.

Few have written more about the European financial crisis since 2008 than the Nobel laureate, New York Times columnist, and Princeton economics professor Paul Krugman. After five years, it is clear that the eurozone has survived contrary to his predictions and the countries that pursued fiscal discipline, contrary to Krugman's advice, have done better -- both economically and politically -- than those that did not.

Since Krugman represents the mainstream of Anglo-American economic commentary and enjoys both popularity and an impact on policy, a post mortem of his positions in the European financial crisis are of broader relevance. The problem is not the odd flawed prediction -- everybody makes such mistakes -- but an unhelpful thinking about fiscal policy of which Krugman is the prime representative.

I was first struck by Krugman's misperception of the European financial crisis back in December 2008, when he wrote a blog post that baffled me. It was titled: "Latvia is the new Argentina." The comparison was bizarre. Argentina is a large, closed economy that has mostly pursued populist economic policies, while Latvia is a very small, open economy, a member of the European Union with small public debt and excellent business environment. The only similarities were financial crisis because of large current account deficits leading to an absence of market financing.

Based on this facile analogue, Krugman concluded that Latvia would then have to devalue as Argentina had, but of course that didn't happen. The Latvian government ignored his advice. It stuck to its peg to the euro and carried out a draconian fiscal adjustment, which quickly restored confidence and prompted plenty of structural reforms; it is now the fastest growing economy in Europe. Krugman's mistake was to look at only a couple of indicators and draw a simplistic analogue.

Krugman's most spectacular failure has been his prediction of the dissolution of the eurozone. As Niall Ferguson has noted, Krugman "wrote about the imminent break-up of the euro at least eleven times between April 2010 and July 2012." Well, that didn't happen. Not only did the eurozone remain intact but in 2009, Slovakia joined, as did Estonia in 2011; Latvia is set to join in January 2014.

While anyone can make a mistake, Krugman's error was more profound, indicating a lack of understanding. He treated the eurozone as primarily a system of fixed exchange rates, ignoring that it is a currency union with centralized clearing of payments. As the euro crisis evolved, uncleared payment balances piled up. The best way of dissolving these imbalances was by restoring confidence in the euro system, which the European Central Bank (ECB) has done, sensibly, since July 2012. A breakup of the eurozone, on the other hand, would have resulted in large debts and claims of the various members, leading to major financial destabilization.

In the last century, three multi-nation currency unions in Europe have endured disorderly breakups -- namely the Habsburg Empire, Yugoslavia, and the Soviet Union. In each case, the outcome was multiple hyperinflations from which several countries have still not recovered two decades later. To my knowledge, Krugman has never mentioned this aspect in print. Nor was it self-evident that the EU and its single market would survive if the euro system broke up. This was truly unchartered territory. However, ECB President Mario Draghi did understand the dangers, and in July 2012 he declared that ECB would "do what it takes" to save the euro. And while Krugman advised against saving the euro, he had (rightly) praised the "do what it takes" philosophy.

When it comes to fiscal policy, Krugman is single-minded in his focus on aggregate demand rather than supply, seemingly unaware of how constrained supply has been in the EU, not least because of overregulated labor and service markets. He has persistently favored fiscal "stimulus," larger budget deficits, and slower fiscal adjustment. Today, the record is clear. The countries that have followed his advice and increased their deficits (the South European crisis countries), have done far worse in terms of economic growth and employment than the North Europeans and particularly the Baltic countries that honored fiscal responsibility.

Luckily for European democracies, the ultimate verdict on crisis management belongs to the voters. During the five years from October 2008 until September 2013, eight EU governments -- in Estonia, Finland, Germany, Latvia, Luxembourg, the Netherlands, Poland, and Sweden -- have been reelected, hanging onto power even in the face of economic crisis. These governments were the ones that pursued responsible fiscal policies often called austerity, contrary to the policies Krugman prescribed. Apparently, large budget deficits are not very popular with voters. In 2012, the average budget deficit of these eight countries was 1.6 percent of GDP to compare with 4.8 percent of the 19 countries, where the governments have been ousted. The voters seem to have got it right. The economies of the eight virtuous countries grew by 1.4 percent, while the economies of the 19 others contracted by 0.8 percent.

If we examine the reasons for this outcome, it does not appear surprising. The only economic argument for a slow fiscal adjustment is that the fiscal multiplier, that is, the ratio of change in national income to the change in government spending, might be uncommonly large in the first year (as the International Monetary Fund [IMF] has claimed in one research paper, though, in the literature there's no clear-cut agreement that the fiscal multiplier is so great). Moreover, five years after the bankruptcy of Lehman Brothers, we are no longer talking about the short term of one year but the long term of five years.

Many more arguments favor an early fiscal adjustment -- namely that financing is often not available, that European countries needed to trim their public expenditures, and that Europe's key problem was structural. Krugman's problem is not his view on these issues but that he persistently ignores them, as if they did not matter. In his world of economics, little matters but aggregate demand.

For many countries in jeopardy, international financing is not available. Since the average public debt in the EU had risen to 91 percent of GDP in 2012, hardly any country but Luxembourg and Sweden had fiscal space to pursue fiscal stimulus. Among the 28 EU countries, no less than eight needed international financial assistance not available to them on the market -- Hungary, Latvia, Romania, Greece, Portugal, Ireland, Spain, and Cyprus. Therefore, fiscal stimulus was not an option because bond yields and interest rates had surged sharply and surprisingly.

In late 2008, for example, Latvia and Romania lost market access when their public debt was less than 20 percent of GDP, showing how minimal their fiscal space was. Yet, Krugman ignores that many small countries find it difficult to raise international financing in times of crisis.

Krugman's persistent pleas for more fiscal stimulus presumably contributed to the IMF pushing countries such as Spain, Slovenia, and Cyprus to increase their budget deficits impermissibly to about six percent of GDP, far more than they could finance, in 2009. After these countries had expanded their budget deficits, they could not cut them, which is not very surprising. This raised their bond yields and put them into financial hazard.

All European countries have excessive public expenditures that need to be trimmed because they harm economic growth, which Krugman refuses to acknowledge. To his horror, the Baltic countries carried out a fiscal adjustment that consisted of two-thirds expenditure cuts and one-third higher taxes. The southern Europeans, by contrast, mainly raised taxes, which Krugman was less opposed to. As a consequence, even in 2012 Greece had 55 percent of GDP in public expenditures, significantly more than Sweden (52 percent) and far too much to allow significant growth. Obviously, Greece should have cut expenditures faster so that their public debt as in the Baltics.

The key European problem, which Krugman persistently ignores, has long been constrained supply because of poorly functioning markets for labor and services, which led to low growth before the current crisis. Front-loaded fiscal adjustments made ample structural reforms necessary in the Baltic countries and Bulgaria and caused great economic growth in the Baltic countries, while Greece has only recently started undertaking significant structural reforms. Major structural changes are both necessary and appreciated. Latvia cut public wages by 26 percent in 2009 and sacked 30 percent of its civil servants in 2009 without any public protests, while public unrest was ample in Greece until the government started sacking civil servants. In the last year, it has been minimal.

What Krugman refuses to see is that front-loaded fiscal adjustment quickly restores confidence, brings down interest rates, and leads to an early return to growth. Thanks to greater structural adjustment, the growth trajectory is likely to be higher in countries that quickly and enthusiastically embrace these reforms than elsewhere. Accordingly, the three Baltic countries that suffered the largest output falls at the outset of the crisis because of a severe liquidity freeze returned to growth within two years and have, over the same period, enjoyed the highest growth in the EU. By contrast, Greece, with its back-loaded fiscal adjustment, as recommended by Krugman, has suffered from six years of recession.

Krugman also worried at length about the risk of a "competitive deflation" because of large wage cuts. But deflation has hardly occurred anywhere in Europe. Even in Latvia, where unit labor costs in the whole economy declined by 25 percent in 2008-2009, consumer prices fell by just 1 percent in 2009. Part of the explanation is that productivity in Latvian manufacturing rose by an extraordinary 50 percent in 2008-2011 thanks to an early and radical fiscal adjustment and impressive structural reforms. The evidence points to the success of these measures; Krugman just refuses to see it.

Throughout the European financial crisis, Krugman has provided poor advice on how to pursue fiscal policy. The successful EU countries recovered by doing the opposite of what he recommended -- while those governments that followed his advice on slow and back-loaded fiscal adjustment, or even fiscal stimulus, have failed miserably. During five years of extensive writing on the EU financial crises, Krugman advocated depreciation, but maintained that pegged exchange rates worked perfectly well.

Contrary to his predictions, the eurozone has survived. He advocated fiscal stimulus, but rapid fiscal adjustment turned out to be the best cure for both public finances and economic growth. He ignored that all EU countries had excessive public expenditures and needed structural reforms. Nor did he understand the general mood of Europeans, as clearly expressed by their electoral preferences, though that didn't stop him from expressing strong views to the contrary. And he has favored social democracy, which European voters have widely rejected to the benefit of the moderate center-right, which has never been stronger.

The reasons for his misperceptions of European economic policy are manifold. Krugman did not look upon the relevant variables and ignored all but a few facts. He adhered to a simplistic macroeconomic view that more fiscal stimulus is always better, which should make poor John Maynard Keynes turn in his grave. It's hard to overcome the suspicion that Krugman actually had the United States and its problems in mind when he was writing about Europe. The real problem is that these two parts of the world are quite different.



The Nuclear Handshake

Is the Pakistan-Saudi weapons program for real?

BBC Newsnight, a British equivalent of ABC's 20/20, ran a story on Nov. 6 saying intelligence reports judged that Pakistan was ready to deliver nuclear weapons to Saudi Arabia. The purpose would be to counter Iran's perceived nuclear weapons program: "It is now possible that the Saudis might be able to deploy such devices more quickly than the Islamic republic [of Iran]," the report concluded.

The story ran the night before the next round of talks between international powers and Iran in Geneva. The implicit message was that Riyadh had a fallback option in case a deal is cut with the Islamic Republic that is not to its liking. Some may be skeptical about the report due to the denials of both nations and some vagueness about the source of these claims, but dismissing the report out of hand would be foolhardy: The outline of the Newsnight story has been circulating among Saudi watchers for several months as Riyadh's frustration with Washington over its Middle East policies have grown.

Although the latest information does not appear to have come from Saudi Arabia -- an unnamed "senior NATO decision-maker" was cited as the principal source -- any transfer of Pakistani warheads or missiles would fit neatly into the category of "ways the House of Saud could make things unpleasant for Washington."

Well before the uprisings of the so-called Arab Spring, King Abdullah regarded the threat of a nuclear Iran as a major destabilizing force. More than 10 years ago, the Guardian reported the kingdom was debating a strategy paper setting out three options: acquiring a nuclear capability of its own, maintaining or entering into an alliance with an existing nuclear power that would offer protection, or trying to reach a regional agreement on a nuclear-free Middle East.

In February 2012, a correspondent of the London Times was summoned to Riyadh, where he was told by an unnamed senior Saudi official that the kingdom could acquire nuclear warheads "within weeks" of Iran developing atomic weapons. In the event of a successful Iranian nuclear test, Riyadh would "immediately launch a twin track nuclear weapons program," according to the Saudi source, while warheads would be purchased "off the shelf" from abroad. At the same time, the kingdom would upgrade its planned civil nuclear program to include a military dimension.

President Barack Obama's administration will find it challenging to shrug off these stories as mere rumors. Among those interviewed by Newsnight was Gary Samore, until recently the National Security Council's WMD czar, who expressed his belief that the Saudis have an understanding "that, in extremis, they would have claim to acquire nuclear weapons from Pakistan." (Full disclosure: I was interviewed for the program and some of my sager comments were included in the film report.)

In a studio discussion that immediately followed the film, Sir William Patey, who was British ambassador in Riyadh from 2006 to 2010 and had previously been in charge of the Middle East department at the Foreign Office, did not contradict the report.

The collaboration between Saudi Arabia and Pakistan on Islamabad's nuclear program has deep roots that could go as far back as the early 1970s, when Saudi King Faisal agreed to fund what is now the main mosque in the Pakistani capital of Islamabad. Riyadh was almost certainly also tapped for funds by then Prime Minister Zulfikar Ali Bhutto to pay for Pakistan's uranium enrichment program in the mid-1970s -- when the enrichment plant was revealed in 1979, diplomats and journalists in Islamabad saw the kingdom as one of the only likely sources of funds for such a project. The head of Pakistan's nuclear program, A.Q. Khan -- who was later condemned for proliferating nuclear technology to Iran, Libya, and North Korea -- told me he visited the kingdom more than 40 times and was offered citizenship by one of King Abdullah's half-brothers.

In 1999, Khan hosted Saudi Defense Minister Prince Sultan at the Kahuta uranium enrichment plant outside Islamabad, along with Pakistani premier Nawaz Sharif and Army chief Gen. Pervez Musharraf. The general would overthrow Sharif a few months later, sending him into exile in Saudi Arabia, an altogether more comfortable interlude than the inside of a Pakistani prison.

Sultan also saw more than Kahuta's enrichment centrifuges: He was also shown a mock-up of the Pakistani bomb. According to A.Q. Khan, Khalid bin Sultan, the defense minister's son, tried to pick up the hemispherical "tamper," which is used to contain the initial moment of the nuclear explosion, but it was too heavy for him to lift.

Some may expect U.S. intelligence to know every in and out about such dealings, but Washington's knowledge of Saudi military planning has not always been perfect. In 1988, the kingdom took delivery of Chinese CSS-2 missiles even before Washington realized that Saudi Arabia and China had inked a deal two years earlier. The missiles were spotted by a U.S. satellite being trucked to launch sites south of Riyadh, having been flown in on giant transport aircraft that landed at a private airport on a farm belonging to Prince Sultan.

Those missiles, previously part of China's nuclear strike force, were arguably already obsolete, being liquid-fueled with unstable industrial alcohol and nitric acid. The immediate fear in Washington and other Western capitals was that they had come with nuclear warheads, though Riyadh insisted that they only contained conventional explosives. In another twist, the atomic bomb design that China gave Pakistan in 1982 would fit nicely on a CSS-2 -- Pakistani scientists redesigned it to make it fit on one of their own missiles.

Last week's reported schism between Riyadh and Washington was supposedly patched up by the visit of Secretary of State John Kerry to Riyadh on Monday. According to former Saudi intelligence chief Prince Turki al-Faisal, addressing a private group in Washington on Nov. 6, the two men "exchanged the frankest words ever."

But all the frank talk in the world may not convince Riyadh to back down if it believes Iran is on the path toward a nuclear weapon. The best the Obama administration can probably hope for at the Geneva talks is to convince Iran to place restrictions on its nuclear program -- actually stopping it seems increasingly unlikely without the use of military force. In these circumstances, the Saudis may well judge that the years of preparation they have devoted to going nuclear were well spent.