...against fictions and other tall tales

Friday 11 November 2011

Deficit myths (Part 2): The effect of deficits on macroeconomic stability

Paul Krugman is right in saying that the crisis in Europe has absolutely nothing to do with Europeans' preference for an extensive welfare state. As Krugman demonstrates, there is simply no reason to believe that the deterioration in the public finances of European nations now affected by the debt crisis was caused by the financial cost of welfare policies in those nations.

Indeed, I would add that the claim that welfare policies are somehow responsible for the current debt crisis in Europe is particularly implausible in the case of the Spanish government, which, prior to the financial crisis and ensuing recession, was actually running sizeable fiscal surpluses (see Chart 1). This fact alone should be sufficient to dispel the myth that the current European crisis was the result of uncontrolled and unsustainable government spending. (See Addendum below for data on Ireland and Iceland)

Chart 1: Cash Surplus/Deficit for Spain, Source: St. Louis Fed















In fact, in regard to the causes of macroeconomic instability, there is very little empirical evidence to support the view that public sector debt and deficits cause debt crises or have any significant impact on macroeconomic stability. This was demonstrated recently by the research staff of the International Monetary Fund (IMF) in the May 2010 edition of the IMF Fiscal Monitor (2010:67).

As you can see from the chart contained in the Fiscal Monitor (see below), the relationship between government debt as a percentage of GDP and macroeconomic volatility is extremely weak.* The reason for this is that financial crises can afflict nations with either small or large debt burdens. Examples of nations with relatively small debt burdens that were impacted by a financial crisis include those nations affected by the East Asian crisis in the late 90s.

Chart 2: Macroeconomic volatility and debt level, Source: IMF

















* The purpose of the red horizontal line in the chart is to show that the level of volatility is more or less the same at any ratio of debt.

Reference

IMF, Fiscal Monitor: Navigating the fiscal challenges ahead, World Economic and Financial Surveys, May 2010

See here to read Part 1 of this series on deficit myths: The effect of deficits on interest rates

Addendum (added on November 11, 2011)

Central government debt: Ireland, Spain, Iceland, Source: St. Louis Fed















Central government surplus: Ireland, Spain, Iceland, Source: St. Louis Fed

6 comments:

  1. Ireland and Iceland were also countires running sizeable fiscal surpluses prior to the crisis (with bankers gone wild of course). The funny thing is that both were poster child countries of how a national economy should be ran for a big chunk of the economist profession.

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  2. Thanks JL, I added charts in an Addendum with data on Ireland (blue), Spain (red) and Iceland (green).

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  3. Fine article, circuit nod!. With all due respect to PK, I think you did a better job debunking Krugman's 'welfare demons' than PK did himself. He would be impressed.

    As a second, I was linked to your conversation with NW et al on heteconomist. Good exchanges. The site is good.

    I think it pragmatic ( for both theory and policy)to deal with factual events and states of affairs especially when attempting to establish legitimacy in a world of complex organizations (here I follow Simon and CAS premises). On the other hand I commend the position that wants it all. Unfortunately, policy doesn't work that way. Policy addresses factuals and tries to preclude or minimize the risks of unintended consequences, something that dabbling with 'ideals' usually encumbers. There could be numerous political permutations and each would necessitate a variant circuit.

    As far as my reading of the exchange, you didn't preclude a consideration of ideals, you preferred a less polemical and more pragmatic approach.

    As far as falling into 'conventional' traps, once the paradigm shift is processed, the conventions fall apart and the language as well as the optics are irreversibly transformed to represent the paradigm. I see no 'ghost' haunting the new institutions.

    But nod to Wilson, he wants it all, and that's commendable. But so did Smith and Marx, to think it all.

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  4. thanks for the Lavoie link. quite honestly, much of the 'MMT' blogsphere reminds me of a good car spinning on ice. it is a recital stage...and in the end, very little value is added by that medium. i don't want to conjure the worst but Lavoie's paper was far too generous towards some and far too lenient with others.

    he stands in a class of his own as does his ottawa colleague Seccareccia when it comes to pivoting (post)-keynesian positions intelligently.

    i guess mending fences is the first reasonable step in the symbolic breaking down of walls. maybe Lavoie wants to unite the theoretical positions. good luck

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  5. There's a rule of thumb that designates supposedly keynesians as promoting first price stability. It's a rule of thumb paneled in the Keynes-for-the-birds pulps, where the birds are usually the authors. JMK was and is foremost about full employment. Nod to the lot above that remind the birds that their eyes-view is nought (allow the archaic)

    I trust that Draghi will not mime Lagarde's rhyme on deficits, and that along with Draghi, Papademos and Monti remember their alma maters. What Europe needs is jobs, not razes on expenditures, otherwise, we'll end up with a Wasteland on all sides of the oceans, the likes of which has n'er been seen.

    No one should delude themselves in the illusory improvements of Ireland and Iceland-sovereign categories that have little political and social semblance to Italy, Greece and Spain.

    The emphasis on austerity is quasi hysterical. Stay the course Circuit.

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  6. JH, GC: the alternative paradigm that MMT and circuit theory present is also highly compatible with the accounting perspective contained in systems of national accounts. It's a useful approach for interpreting the flows from the private sector to public sector, and vice versa. From an analytical standpoint, it's also effective for determining the effect on the economy of past treasury policy. IMO, its policy recommendations are in line with the best that Keynes, Tarshis, Lerner and Boulding had to offer. Add to that the more recent focus on the endogenous nature of money and the implications of a monetary, credit-based economy (à la Schumpeter/circuitiste), the paradigm should be the workhorse of pragmatically-oriented policymakers. Had the framework been applied in 08'-09', we'd probably be talking about supply sectoral shortages in the workforce by now. In sum, I agree with your comments. Big victories usually arise after years of small, incremental changes in approach (Lindblom applied to paradigm shifts). Idealism too is necessary, but pragmatism must prevail in the end. (See Colander, 'Keynes a Keynesian or Lernerian, p. 1574)

    http://community.middlebury.edu/~colander/articles/was_keynes_keynesian.pdf

    Swells, I agree: if your eyes aren't on the rate of unemployment, you're probably reading the wrong books or listening to bad advice. Period. BTW, I'm not too optimistic about the replacements.

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