Ireland and Austerity : Is Paul Krugman wrong?

In a recent article in the New York Times Paul Krugman took the US deficit hawks to task, he argues that Ireland’s approach to austerity has not been rewarded by the markets.

Consider, if you will, the comparative cases of Ireland and Spain.

Both countries appeared, on the surface, to be fiscally responsible until the crisis hit, with balanced budgets and relatively low debt. Both discovered that this was an illusion: revenues were buoyed by immense real estate bubbles, and when the bubbles burst they plunged into deficit — and found themselves potentially on the hook for large bank losses.

The countries responded differently, however. Ireland quickly embraced harsh austerity; Spain has had to be dragged into austerity, and still faces major political unrest.

Krugman then points to two data points for each country that show the price of a Credit Default Swap (which correlates to the risk that a country will default on it’s debt) is higher for Ireland than for Spain and another set of data points that show the yields on Irish bonds are higher than Spainish bonds.

The article is discussed over on Irish Economy and on Progressive Economy. Michael Burke highlighted a time series showing worsening of Irish bond yields vis-a-vis German and Belgian yields, and on his article on Progressive Economy provides a graph showing no significant long-term improvement in Irish bond yields vis-a-vis Spanish bond yields (however, the graph does show a significant disimprovement as the banking crisis struck in 2008 thereafter followed by some improvement in Irish bond yields relative to Spanish yeilds – the yield on Irish bonds fell by aprox 17% peak-to-trough, while Spanish bonds held steady. Graph available here).

However, a commenter on the Irish Economy thread (Mark Hutchinson ) linked to this interesting graph – which makes the relative performance of various European countries CDS ratings apparent. While the price of a Credit Default Swap is higher for Ireland, the Spanish price (and the price of some other European CDSs) have risen more over the past year and a half.

So who is right? I recommend taking Paul Krugman’s approach of trusting your own lying eyes. But remember at the very least we have to be careful with the statistics we use and given the complexity of the events that occured very careful in how we interpret them – or more accurately spin them. When attempting to interpret them this explanation of the narrative fallacy, described by Nassim Nicholas Taleb in the Black Swan, might help.

PS – FWIW – I’m generally in favour of using an increase in capital spending to offset the contractionary effects of rebalancing Ireland’s fiscal position providing the multiplier from such investments is significantly greater than 1, and the investments themselves are made in productively (i.e. no pork / bridges to nowhere).

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  • Alias

    To answer Klugman’s title question: yes, it reassures markets that the state is cutting spending on its citizens in order to ensure that it has more money available for debt repayment to those markets than would otherwise be the case. That works best when the government makes no claim that it is cutting public spending for any other purpose, e.g. to reduce the account of money that it confiscates from its citizens in the form of taxation. But it is just one dyanamic of many that markets and ratings agencies will use to calculate a state’s credit rating, so it doesn’t follow that austerity measures will determine the CDS rate or that it can be claimed that such measures are disregarded by the markets because the CDS rate increases.

  • anon

    “Klugman”? Dear God, I thought this was athread for adults.

    This is a hard question to answer. If the markets decided early that Ireland was a risk and attracted trouble, then austerity might be necessary and also still produce a bad comparison with other countries. At least for a time. The alternative of no action might well have been worse. Though perhaps Spain also being seen as a bad risk undermines the point; though maybe it’s harder to mount an attack on the larger economy. It might also mean that higher rates persist for a shorter time. We’ll not really bget a clear sense of what the best policy is until we’re out of this, I think.

    I think he has a fair point though, when he points to the discomfort that people have with lower rates, even when the models people write tell them its the right thing to do. The moralism is not necessarily a good guide to the correct policy, and trying to base policy on what you think the market will do is surely madness, up or down. Time is better spent on a long term budget fixes needed, and a back up plan for quick actions if the market turn. But if you can borrow low then that’s the way to go until the economy looks self sustaining, then you should be grabbing it.

    The UK is a prime example. The 6 billion of cuts this year is chump change. They may be good in themselves but does anyone believe it matters a jot to the markets? It’s the long term fix they will attempt with the review will matter

    Adam Posens quote he highlights is a classic, too

  • Mack

    It’s like a Rorschach blot test – people see what they want to see in it.

    I think Taleb is right.

    The Keynesians looking at the graph of Irish CDS prices tell themselves “austerity has not reduced the price of insuring Irish debt”
    Deficit hawks looking at the CDS prices relative to those of other Europeans, they see them getting worse and say “there but for the grace of god, go us”

    The problem is, ultimately, no-one really knows what’s driving the changes with any degree of certainty. They’re both just narratives, convincing to those who tell them, because they fit their own world view.

    The Onion satirised this best.

  • Anon

    But if Irish debt is already at high levels, and the other econmies are only getting worse but have not reached that level, then it implies that there is a significant time window for governments to expolit.

    Plus the dynamics of this are questionable. Is there a Tipping Point? What causes it (fundamentals or simply market modd), and does austerity actually help if you pass it?

  • Mack

    Ireland’s debts were low, much lower than the others, but increasing faster (higher deficit) & we had probably the biggest credit bubble bursting, the banking garuantee etc. I’m not sure if we can really tell anything useful from the graphs.

    Whether Austerity is the right track is another matter. We had a much better chance of being successful when we were the only ones doing it – indeed we could ride on the coattails of others stimulus packages. It’s a different kettle of fish nowadays.

    Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0

    You can’t have private sector deleveraging, public sector deleveraging and a balance of trade deficit at the same time. Ireland has private sector deleveraging, public sector debt increasing (despite austerity) but not enough to offset the private sector deleveraging and a balance of trade surplus. Other Europeans are in a worse state – private sector deleveraging with balance of trade deficits and uncompetitive economies. For every Euro of surplus one country runs, some other country must run a Euro of deficit (i.e. borrow from abroad to import).

    At a higher supranational level – Krugman is probably right, or maybe we need inflation, debt forgiveness or something – but still a country that implements a badly planned stimulus package could easily just end up feeding other countries attempts to get into balance of trade surplus..

  • Alias

    Mack, there is no mystery to how markets calculate risk. Why not pop over to a CRA such as Standard & Poors’ website, for example, and they’ll even tell you? One thing they don’t look at is economic forecasts that are outside of the spread. Inside of the spread, the key is cashflow. Hence “austerity measures” simply means that the State is cutting public spending in order to ensure that it has the cash to repay its debt. It doesn’t mean that the market sees a Klugman (sorry, Kensei) as the minister for finance…

  • Mack

    Defining a credit rating is a much more simplex task than determining a market price (rather than having some Quant calculate what they think the price should be). Information flows are incredibly complex, and contrary to myth I don’t think market participants have perfect information.

    The problem with austerity measures en masse, while indebted private sectors are deleveraging, is that it forces countries to reduce their imports (i.e. their demand for foreign goods). The side-effect of this, if everyone does it simultaneously, is that you don’t get a better balance of trade (and an improved ability to pay down debt), just less imports and less exports – i.e. lower global /regional / European demand but the same mountain of private sector debt to repay.

  • Mack

    Obviously some countries are in more dire need of tackling their national debt than others. Why Germany is implementing austerity is beyond me. If they increased German wages – that would increase demand in Germany for goods from other European states and allow countries like Greece, Spain, Portugal to improve their balance of trade by actually competing with German products.

    Alternatively if the ECB would engineer some inflation Portugal, Greece, Spain, Italy could improve their competitiveness by holding wage levels down at or below inflation while the Euro surplus countries allowed their wages to rise at a higher pace.

    Or maybe we come up with an EU exit mechanism so the (balance of trade) deficit countries can devalue to become competitive.

  • Mack
  • Anon

    And of course, you also risk deflation particularly in the current environment where interest rates are so low there is nowhere for them to go. And if you wind up in deflation, you’re debts actually cost mroe in rela terms.

    What happened to Irish inflation?

  • Mack

    It’s back positive again (inflation).

  • Anon

    Which would be a good thing. I would guess not high, though.

    Bit more discussion in the New Yorker:

  • Driftwood
  • Richard Rawls

    I would suggest that Richard Koo is right and that you start to pay more attention to him;