Tuesday, 15 June 2010

Krugman & lying eyes

Michael Burke: Paul Krugman, writing in the New York Times, asks whether fiscal austerity measures actually reassure the financial markets. This question is of course extremely pertinent to this economy. Not only has the FF-led government led the way in slash&burn economics in Europe, but this has become a defining totem of its economic policy - that the cuts are necessary to reassure financial markets.

Government policy was recently commended by the Wall Street Journal, and duly got a widespread airing. Krugman's analysis is very different and by implication much more critical of policy. I'm guessing his piece will get much less of an airing on the radio shows and might not be reproduced by the Irish Times. Just a hunch.

But who is right, the WSJ, or the NYT's Nobel-winning economist? The only way to judge is in their treatment of facts. Specifically, both articles refer to the reaction in the bond market to Dublin's economic policy, and the contrast with that of Madrid. Krugman points out that Irish 10yr bond yields are higher than Spanish ones, despite the fact that the latter had to be recently strong-armed into fiscal austerity and there has been a public backlash against the measures. He also points that Irish Credit Default Swap rates are higher than Spanish ones. Although these are less reliable guides than bond yields, because they are smaller, more illiquid markets, they do indicate that more speculators are betting on an Irish default than on a Spanish one. Helpfully, Krugman provides links to Bloomberg charts, so the facts at least cannot be contested. In neither case can it be argued that the fiscal austerity here has provided greater reassurance to the markets.

But what of the Murdoch-owned WSJ? It certainly uses lots of facts to support its argument that policy here is correct, and should be emulated. But how it uses those facts is less than rigorous.

To take the key area of disputed ground, bond yields, this is what the WSJ says in its opening paragraph, "SPANISH TWO-year government bond yields climbed five basis points to 2.47 per cent on Monday morning, after Fitch last week cut Spain’s triple-A credit rating to double-A-plus. Ireland, on the other hand, has been making do with its diminished Fitch rating of double A-minus since November. And yet yesterday morning the yield on its two-year government bond was at 1.77 per cent, down seven basis points from the day before, though its 10-year yields remain elevated." The full piece can be read here.

It is perfectly true that Spanish 2-year government yields are higher than Irish ones. But the WSJ article glossed over the fact that Spanish 10-year yields are significantly lower as they have been throughout the crisis. This is shown in the chart below.


10-year yields are the accepted benchmark for government debt, as prudent government borrowers attempt to lengthen the maturity of its debt precisely to avoid being hurt by wild short-term swings in market sentiment. Less than 20% of government debt is held at short-term maturities like 2 years, the bulk held at much longer maturities. So, while the WSJ treated us to a daily commentary on Irish 2yr yield movements, it passed over a key fact; that Irish long-term yields are higher than Spain's where it counts, which is where most of the borrowing is done. The grudging admission was that Irish 10yr yields 'remain elevated'.

All the crisis-hit countries in Western Europe, Greece, Spain, Portugal and Italy are suffering a fate that has already befallen Eastern Europe. International bodies such as the ECB, European Commission, IMF, etc. insist on austerity policies to reassure financial markets. Sometimes local governments are happy to oblige, others need arm-twisting. But the austerity doesn't reassure financial markets, so more of the same is demanded, and yields rise because bond investors think that the risk of default is rising, as Krugman points out.

Within that general trend, there seem to be favoured countries and not so favoured ones. These are the ones under attack and whose 2year yields are pushed higher as governments find it hard to access short-term funds. But it seems to have little to do with deficits- Italy's deficit is expected to be 5.3% of GDP this year the same as Belgium's, compared to 8% for France and 11.7% for Ireland. And it seems to have precious little to do with debt levels either, with Spain's debt at 64.9% of GDP this year, compared to 77.3% for Ireland, 78.8% for Germany, 83.6% for France, and 99% for Belgium. It does have a lot to do with the scale and foreign assets of each country's banking system, but that's another story http://socialisteconomicbulletin.blogspot.com/2010/06/parasite-threatens-host-impact-of.html .

Irish 10yr yields were the highest in the EU for most of 2009, as austerity was being implemented, in contrast to the rest of the Euro Area, where various types of stimulus measures were attempted. The reassurance that bond investors need is that you can meet interest payments and repay debt as it falls due. For governments that can only come from tax revenues.

Krugman ends with a question, should you believe what everyone knows, or your own lying eyes?


Paul Hunt said...

Perhaps the markets are factoring in the billions that will be chucked into the Anglo and INBS black hole and expressing some doubt about Ireland's future debt servicing capacity. No other EU country has a mill-stone that is proportionate in size and weight.

Donagh said...

This is all very confusing. Over on Irish Economy Karl Whelan agrees with Paul Krugman about the damaging effect on bond yields, “of imposing fiscal austerity too soon” (so has government policy regarding austerity which Karl Whelan supports wrong up to this point?) and then says that the Irish Government has no choice because the bond markets, which are reacting unfavourably to imposed austerity plans as an indication that we might not be able meet our medium to long term debt obligations, would punish us if we decided to reduce our austerity measures.

He then says, referring to Krugman’s Erin Go Broke, that Krugman agrees with him. And he’s right, because in that piece Krugman completely contradicts what he said in the June 13th blog post “Does Fiscal Austerity Reassure Markets”.

“But there isn’t much disagreement about the need for fiscal austerity. As far as responding to the recession goes, Ireland appears to be really, truly without options, other than to hope for an export-led recovery if and when the rest of the world bounces back.”

To make matters more confusing, Karl Whelan’s article in Business & Finance which he posted on Irish Economy seems to contradict his concession about the rightness of Paul Krugman (modulated by the cavet that “few cross-currents here”) and his own point in that post:

“I noticed Leo Varadkar of Fine Gael saying on TV that he thought this planned adjustment was too large. However, sovereign bond markets have become far more nervous in recent months and a failure to stick with our announced plan for adjustments could very possibly see the Irish government shut out of this market, thus becoming reliant on the EU\IMF stabilisation fund. The price of accessing this fund would almost certainly include a more rapid pace of adjustment than is currently planned. Hopefully this represents a solo run from Deputy Varadkar, as a cross-party consensus on the need for the government to stick to its planned path of fiscal adjustment has been one of the key elements distinguishing Ireland from countries like Greece.”

Orthodox economics, very complicated all together.

Anonymous said...

It is that simple: if you run a 11% GDP budget deficit, with budget revenues declining, and you also guarantee all the bank's debt - maybe bond investors get a bit nervous that humpty dumpty will break into pieces? There is no austerity here in Ireland - just a high spending government that guarantees every liability in sight. Krugman never noticed this because he has been sucked in by all the other commentators who make the same mistake.

Mack said...

Given that many European states are undertaking austerity measures and inflation is low, is there any good reason why the ECB base rate is at 1%? Wouldn't a 0% rate help cushion the pain somewhat?

Martin O'Dea said...

Excellent piece Michael, thanks again. I know I talk in a decidedly non-economic manner in my contributions here and this is intentional.
I was laughing recently with colleagues discussing the credibility of a certain man in pyongyang who on his first attempt at golf shot a 35! However, it sturck me that one could laugh in exactly the same way for what some believe a God can do; and perhaps at least one can see Kim with a golf club and know that he did actually play.
Once people adhere to something, anything, intellectually there is a corresponding slippery reinforcing slope towards greater illogicality. The 'Market' is a prime example.

i)People produce and consume goods and services.
ii)Individuals thrive only by cooperation and collaboration.
iii)People invest money to make money.
iv)Stock markets, financial services, bond market sentiment are not pre-existing things - they are merely human social constructs.

The question should always be for politicians is what I do good for the people (all in equal measure, necessarily) whom I serve; in the here and now and into the future. It really should not consider bond market sentiment and should certainly not point to this sentiment as a justification for actions to its people. This, of course, is without even acknowldging the dubious nature of references made to support their view of the support they are receiving.

The arguments that take place here seem to me to be often times framed without this contextual acceptance by many contributors.

It is very hard to argue that even if our 10yr yields were performing well we should be pursuing this backward counter-productive death dance; especially on the cusp of any number of technology driven revolutions emerging as fast as you can say - what will they think of next, huh!

It must be incredibly frustrating for you to conceive such intelligent arguements and analysis and pick up a newspaper or watch a current affairs programme here for so much of the last few years without so much as a nod to you and your colleagues at progressiv-economy's efforts. All I can say is please keep trying. More and more people are looking for change - we must hope that the change appears in the form of greater logic and not less, of less adherence mentality and more informed debate and certainly of less extremes than looks currently possible

Aidan R said...

This is a link to a paper by Immanuel Wallerstein.


He points out that the day after Spain introduced a €15 austerity package its debt ratings were downgraded from AAA to AA+

Why? Because deep cuts harm economic growth. Credit ratings are judged on economic growth. Cogito, budget cuts impact negatively on credit ratings.

Orthodox economists are winning the argument on definition (reduce deficit = good, government spending = bad) not argument or criticisable validity claims. The rules of the game are rigged.

Chris said...

As Donagh said above, this is confusing.

The numbers are clear and reinforce the fact that nobody believes you can cut your way out of a fiscal mess. As a result, the debates rages on in the UK and Germany with economists, in general, warning about cutting too soon and sparking a further drop in the economy. When it comes to Ireland, though, we get special pleading. Deficit Hawks, to use Krugman's terminology, here have failed to adequately distinguish Ireland from some of the other 'small, open' economies in Europe. The typical response is some vague incredulity when comparisons are made with Belgium but little in the way of explaining why it is so different.

Another trend among the cut fetishists is that they themselves are bereft of any ideas on how to emerge from the recession. Take Constantin Gurdgiev's article in the June-July issue of Village (I choose this because I think it represents the best analysis put forward by a 'Cut Fetishist' so far): he points out that Ireland is 'not getting any better', although he does not refer to the fact that this is despite the cuts we have already made. He disregards the existence of a positive multiplier for any stimulus, although he does not deal with any of the data on that put up here. He argues the country does not have a liquidity problem but rather one of old-fashioned insolvency (This is a good point, although I have a feeling that it has been dealt with here). He goes on the attack against his ideological opponents, arguing that 'the Left' does not have the foggiest idea what we should spend the stimulus money on. This is factually incorrect and a cursory glance at the archives here would put paid paid to that calumny. Finally, Mr. Gurdgiev gives us his prescription: 'adjusted thinking and reform' and 'significant rationalisation of expenditure' (i.e. Big, deep, cuts). Obviously, if the State has nothing to spend on due to services being sold off to private hands or cut to minimal levels then it is unlikely to have a fiscal problem.

In short, Mr. Gurdgiev doesn't have the foggiest idea what to do about the economy. He admits that we are getting no better, and his response is to keep doing what we are doing, only on a more intense level. After that, we must cross our fingers! This is the answer we a receiving from those who are 'talking sense' [sic] on the economy. It is truly a sorry state we are in when so many accept it as gospel truth.