How to get growth

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How to get growth

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Nobel laureate Paul Krugman argues in this Prospect roundtable that countries could beat recession by spending more. Leading commentators ask whether this would make things worse

Paul Krugman, Nick Carn, Rudi Bogni, Kwasi Kwarteng, Stephanie Flanders, Richard Lambert, Samuel Brittan, Shriti Vadera, Gavyn Davies

“Not now,” is Paul Krugman’s short answer to the question of when governments should make cuts to repair their finances. Austerity should be reserved for the good times, he argues; in the bad times—like now—governments should pour money into public spending projects to keep recession at bay.

Four years after the start of the financial crisis, those arguments (and the 2008 Nobel Prize in economics) have made Krugman a figurehead of the case for large quantities of government spending, as advocated by John Maynard Keynes. “Not since the 1930s have so many Americans found themselves seemingly trapped in a permanent state of joblessness,” he says. Recession or even sluggish recovery is unnecessary, in the United States and Europe, he says, in his new book End This Depression Now! The lessons of the 1930s hold good, he argues.

The growth question—or cuts versus spending, as it is called  in Britain—is the greatest political and economic debate of these years. It is central to the clash over how to resolve the eurozone crisis, and to President Barack Obama’s battle for re-election.  Beyond that, it is at the heart of the affliction of the developed world: high debt and deficits, low or zero growth, and ageing populations. Some, looking at the technocratic governments in Italy and Greece, and the standoff between the White House and Congress, have asked whether democracy can deliver an answer: can politicians ever persuade people to vote for austerity?

Krugman’s response is they shouldn’t try; his critics say his prescription will only make the problem worse. In this extended Prospect roundtable, leading economists and commentators take on Krugman over the hardest question of our time.

Paul Krugman: Let me tell you why I wrote the book. I thought it might be helpful, especially now that austerity policies are so visibly failing, to go on the offensive, and say how easy it should be to get us out of the severe slump that we are in.

We’ve just conducted what amounts to a massive experiment on pretty much the entire OECD [the industrialised world]. It’s been as slam-dunk a victory, for a more or less Keynesian view, that one can possibly imagine. We need to do the opposite of what we’ve been doing these past two years and get out of this quickly.

Bronwen Maddox (editor, Prospect): Why do you argue that this is the right prescription not just for the United States but also for Europe?

PK: The US is clearly a purely Keynesian story of a shortfall in demand and plenty of room to reflate [increase economic output by government spending] where the obstacles are partly intellectual but also political. One of our two major political parties is stark raving mad and that makes policy difficult.

The eurozone has a different kind of problem: the single currency without a single government does create a much more difficult situation. Any resolution is going to have to rely much more heavily on monetary policy. There is, in effect, this problem of the over-valuation of the peripheral economies and to have any hope—in addition to supplying, sort of, open-ended liquidity—you have to have a sufficiently high overall eurozone inflation rate that internal devaluation becomes, at least, possible.

And there’s the UK, the only region where you can say it’s truly an unforced error. There is neither the political insanity of the US nor the structural problems of the single currency and so it’s purely a wrong diagnosis on the part of the coalition. In many ways, the UK would be the ideal place to put my prescription into effect, except for the fact that so doing would require an admission of gross error on the part of people in power.

Marwan Naja (director, Prospect): What do you think will happen under Obama’s second administration or a Romney administration?

PK: Actually, there are three scenarios. One—which is not of negligible probability, but not too likely—is that Obama is re-elected and the Democrats recapture Congress. They still won’t have a filibuster-proof majority, but they can be much more aggressive with legislative strategy. In that case, if they are willing to play hardball, we can put my stuff into effect.

Scenario two is a hung government, if you like: Obama in the White House, but Republicans controlling the House of Representatives and even the Senate. Then it becomes mostly a question of political strategy—doing a Harry Truman and hammering the do-nothing Republicans in Congress. The interesting thing with Romney is that we have no idea what he believes, if anything.  [Members of] his supposed economics brains trust are fairly Keynesian, but his party is violently anti-Keynesian. So, we’re probably headed for sharp spending cuts on aid programmes to the poor and then tax cuts for the wealthy, which probably wouldn’t do much to boost spending—in effect a contractionary policy.

Gavyn Davies (former managing director Goldman Sachs and chairman of the BBC, now chairman of Fulcrum Asset Management): Paul, can I ask how Japan relates to today? I was reading your book that you wrote in the late nineties. You thought there was about a 10 per cent output gap [difference between potential and actual GDP] in Japan in the nineties and lots of us said the same thing. Most of us agreed with you on what to do about it. But if you look at Japan now, it’s never closed that ten per cent gap. Do you think that they lost all of that in the supply side [the part of the economy concerned with production and supply] and in the UK now, is it conceivable that we’ve lost a hell of a lot on the supply side and can never get back to that trend?

PK: That’s important stuff. My current take on Japan is that we’re a lot less certain. How do we even estimate output gaps? The way it’s generally done, if you use Hodrick-Prescott [a mathematical tool to analyse the business cycle]—saying the average [output] over some period of time must be the potential [output]—we know that is crazy because if you apply that methodology it says that the US had returned to full employment by 1935. So that can’t be right. Recently I have been saying that it looks as if Japan had been operating more or less at potential again by 2007. So let’s extrapolate that trend. And you need to be a little careful. Let’s say that the growth and output per working-age person between 1991 and 2007 was the real trend and there’s still a significant output gap in the mid-nineties and then a gradual recovery. If that’s right it was nearly as far below capacity as we thought. Did they take a really huge hit to their potential output from their slump? And that’s, of course, the real question.

GD: Probably.

PK: I would actually say probably not—I wish we were much more certain on such things.

GD: I’m not worried about that from the point of view of the US because the supply side in the US can’t have deteriorated in the way some people think. But in the UK, I’m not so confident. In your recent blogs, I was wondering whether you’d underestimated the possibility that the UK supply side has deteriorated?

PK: Yes—if I could retrace my steps over the past two weeks, I would’ve put more work into all that. Here’s what I understand about the UK: we have, obviously, this sharp fall of productivity. So it does not look like there is a big increase in structural unemployment in the UK at all—it’s all productivity. The story being told is, “You have this high-value finance sector and it’s shrunk.” That’s kind of the counterpart of the US version where we said, “We have all these people in construction and that shrank,” but in both cases, by the numbers, [this analysis] doesn’t work. It’s just trivial.

How did this crisis cause productivity to stagnate all across the economy—which I would ordinarily view as somehow the signature of a demand shortfall on the supply side? It does look to me that the attempts to explain the UK productivity performance in terms of a structural shock fail in the same way [that explanations of] US unemployment in terms of a structural shortfall fail.

Peter Kellner (president, YouGov): Paul, where do you stand on Britain’s quantitative easing (QE)? One view is that it has had no effect; another is that without it we would be in a much deeper depression. Also, are there other forms of monetary expansion that could be more effective?

PK: In 2000, Ben Bernanke [Chairman of the Federal Reserve from 2006], myself and others were worried about the Japan example. There were two views about what you could do on the monetary side. One was that by buying non-standard assets, you could get traction [on the economy]. The other was by changing expectations about future inflation you get traction. So what we’re calling QE is the buying of non-standard assets. The evidence is not decisive. You can see maybe some movement in spreads between short and long-term rates, but it’s hard to figure out.

In the US, there was a fairly dramatic impact when we began QE2 [the second round of QE]. But the impact came through an abrupt, upward revision of inflation expectations, which had been plunging, and they reverted back up to two per cent. Was that showing that the actual policy was effective, or was the policy acting as a signal that the Fed was less likely to be inflation-hawkish if, and when, the economy finally recovers?

I would have done it [QE], and I certainly think that it was the right thing to do. Whether it was actually decisive or not, I don’t think I can tell. Would I call for more of it? Yes. The principle states that there is really no harm. At worst, it does nothing.

Kellner: Are there stronger forms of monetary intervention?

PK: You can buy really unconventional assets. If you go in and buy equities, I’m willing to believe that that would really have an impact. Such things have been done. The Hong Kong Monetary Authority ended up buying 14 per cent of the Hong Kong Stock Market back in 1998. That would probably have an effect.

Steve Davies (education director, the Institute of Economic Affairs): I’d like to return to the point you made in response to Gavyn. My view is that it’s extremely difficult to work out if there is an output gap for any economy, even in retrospect. With relation to the problem you identified, one possible explanation is that we’ve had flat productivity for a while, but it was concealed by a credit-driven bulge. Tyler Cowen [economist at George Mason University] has been arguing this. That implies that a lot of the output we’ve had in the last ten years was essentially illusory. And that obviously has implications for your position because it means that we’re in a rather deeper or more difficult hole.

PK: Well, the shift-share analysis [estimation of the composition of growth, and its implications for employment levels] doesn’t work there. If you were operating with above-sustainable employment, then we ought to have been seeing that in accelerating inflation, even if the above excess employment wasn’t in producing useless stuff. If the problem was we had a lot of people doing stuff that was of no use then the rise in construction sector unemployment should be a large share of the rising unemployment, which it’s not. I think there is a lot of kind of blurred thinking about what is demand and what is supply going on here. I don’t think that Tyler is making sense.

Stewart Wood (adviser to Ed Miliband): What would you think the market’s reaction would be the day after the government committed to an expansion on the scale you’ve been talking about? And if it was grand Keynesianism in one country only, how effective would it be without international coordination?

PK: Let’s take a look at Japan—they just had a huge disaster that actually did hurt the supply side of the economy and a substantial boost in spending for reconstruction. And, the ten year Japanese government bond was [offering a yield of] 0.83 this morning. The markets swallowed it with no concern. You could say it would be different some place else, but these stories keep being told and not happening. For what it’s worth also, the last IMF World Economic Outlook said bond markets seem to be responding strongly to growth as well as to deficits and that we’re pretty well in the range where it’s quite arguable that even in the very-short run the growth impacts of a fiscal expansion would reduce your borrowing costs and not increase them.

For the US, I actually am saying we need $300bn a year for an unknown period until we’re out of the liquidity trap. Let’s say it ends up being a trillion dollars. Actually, a trillion dollars in terms of its long-term impact on American solvency is trivial, especially if you’re borrowing at negative real interest rates. So, it ought not to be a big concern. If we believe, at all, in significant hysteresis [a theory that periods of high unemployment tend to raise the rate of unemployment below which inflation begins to accelerate] which I think I do, then, quite likely, the fiscal impact of that borrowing is positive on balance. And the market ought not to respond. This claim that borrowing would set off a crisis in the bond market is based on the belief that the market will respond in a way that our best economic analysis suggests it should not and our best analysis of recent bond market behaviour says it does not. It’s just that some people for some reason have this great confidence that they know how the bond markets will react, and that doesn’t seem to be a really great basis for policy.

Tim Congdon (founder, Lombard Street Research, now head of International Monetary Research): I was intrigued by your remark that QE works only if it involves the purchase of non-standard assets or if it changes inflation expectations. That’s very much at variance with the view of Mervyn King who said that it mattered because it affected the quantity of money, meaning M4 [the measure of money in circulation]. Do you think it matters not a jot whether the effect on money is 2 per cent, 20 per cent or 200 per cent?

PK: I believe it doesn’t matter. With quantity of money, in circumstances like this the causation actually runs from the economy to the quantity of money rather than the other way around. Whatever your broader monetary aggregate is, it’s essentially reflected in the state of the economy rather than driving the state of the economy.

One of the striking features of the original Japanese QE in the early 2000s, which was a true quantitative easing, where they actually did stuff reserves into banks, was that the monetary aggregates—M2—just didn’t move, because the economy didn’t move. We are in this question of what is money? What is the money supply? M3, which we’ve stopped publishing, included some (but not all) repo [repurchase agreements] and clearly repo belongs in there as much as deposits do. Were auction rate securities part of money? I know, I’m starting to sound like the old Radcliffe report from the 1950s and saying, “Monetary policy does nothing!” In normal times, monetary base has big effects. But not in a liquidity trap [where interest rates are low but savings rates are high, meaning any increase in the money supply fails to stimulate growth]. But, I have no idea what the appropriate definition of money is beyond that. If our banking system is 60 per cent shadow banking, what is money?

TC: If the government buys things from the private sector, and increases the private sector’s deposits, that’s not something coming from the economy and QE is clearly of that sort. The second bit I have to ask: are you claiming there is a big difference between fiscal policy in this cycle between Britain and America?

PK: No, I’m not. I believe if UK policy looks somewhat more contractionary, that’s because in Britain it is happening with intent. We’ve had quite a lot of fiscal austerity in the US, but it’s not because Tim Geithner and Barack Obama decided to have a contractionary fiscal policy. It’s because we have deadlock and paralysis in Washington, and states and local governments are being forced into sharp cutbacks. So, I’m not claiming that the worse GDP performance of the UK is especially to be attributed to Cameron and Osborne—which, I think, does not say, however, that they share no blame.

The UK, like the US, ought to be having a more expansionary policy. The confidence effects that were supposed to kick in should have kicked in already. So, it is surprisingly hard to trace [UK performance] to fiscal policy. The big austerity stuff is still ahead in this budget. The US has had substantial austerity; we’ve had quite dramatic cutbacks.

TC: On the IMF figures, the fiscal policy in America and Britain from 2007-2013/14 is virtually identical.

PK: Not quite. In the end it’s about two points on the structural balance [the gap between spending and revenue, adjusted to account for the economic cycle]. But, of course, I don’t actually believe any of the structural balance numbers because I don’t think we have any idea what potential output is here.

Kwasi Kwarteng (Conservative MP for Spelthorne): I have read your book and enjoyed it very much, but one thing you didn’t talk about is the liabilities going forward that we have in welfare provision, in health provision. At the time you’re talking about—after the [first world] war—the demographic profile was such that a bigger workforce could pay for the liabilities going forward. In this instance, it’s a different demographic configuration—so there’s a real fiscal issue, in terms of the ongoing payments we all have and the contracting workforce relative to the population.

PK: If you wanted to argue that the true debt-to-GDP ratio is substantially higher because of those implicit liabilities, you can make that case. Maybe. But the apparent demographics of the 1930s were pretty dismal—there were books out there with titles like Britain Without People. It’s true that they didn’t have the large retirement programmes, but there appeared to be a declining tax base to service, essentially, the debt inherited from the first world war. It’s not as if there was no issue like that even then.

No, the way I would put it is that I’m happy to talk about fiscal-hawk positions that phase in as the economy recovers. With US numbers, the fiscal outlook [federal government commitments for future spending, especially on healthcare and pensions] is clearly non-sustainable. Something is going to have to give. We’re going to need some combination of significant spending restraint and higher taxes. But not now—not while the economy is in a liquidity trap.

I take Brad DeLong and Larry Summers [academics who suggest government spending at a time of depression will pay for itself] very seriously. You can argue about whether they’re using exactly the right algebra. But the case is quite strong that fiscal austerity, under these conditions, is self-defeating. No matter how much you worry about the long-run liabilities, contracting now out of concern for those liabilities is not going to work.

Richard Lambert (former editor of the Financial Times and member of the Monetary Policy Committee, now chancellor of the University of Warwick): We’ve collectively appointed you chancellor of the exchequer, you’re sitting in the treasury with nothing to apologise for, no baggage, you have a massive shortfall of demand in our economy and the liquidity trap as you describe it. What are the tools you have to address those urgently?

PK: We know there have already been substantial cuts in public investments, so right away you can just reverse that. I remember in 2008 talking to Gordon Brown’s people, and they were very pessimistic about their ability, legislatively, institutionally, to start infrastructure programmes.

RL: They cut VAT.

PK: They cut VAT and in general I don’t like tax cuts on the grounds that people tend largely to save them. But a temporary VAT cut, at least in principle, is better than temporary income-tax cuts because it creates the expectation of higher prices further down the road. In the US it’s so easy because we just have to re-hire the school teachers and restart the deferred maintenance on our road systems, and we’re a long way there.

Rudi Bogni (chairman, Northill): Are today’s economies homogeneous enough so that traction instruments—fiscal, monetary or anything—are going to work as envisaged? Is the economy in Mayfair the same as the economy in Newcastle?

PK: Again, here’s where I know my US numbers really well. We’ve got high unemployment in the states which had a huge housing bubble that burst. If you spend money in New York then what does that do for the unemployed in Nevada—in Las Vegas? The immediate answer is that the unemployment rate is 8.5 per cent in New York, it’s 11.9 per cent or something in Nevada, but it’s actually high just about everywhere. If we were much closer to full employment then you might have the question: are we going to be stimulating areas that don’t need stimulus and not those that do? But at this point almost everyone does. If you look at Switzerland, [there were times] when you had nearly full employment in Zurich and high unemployment in Geneva. The absence of mobility was going to be an issue. But this is not the problem for the US at all—there is no prospering sector of the economy.

Stephanie Flanders (BBC economics editor): The critique of austerity in America and the eurozone goes between the two arguments that you have used. One says, in effect, that we’re going to have several years where the government has to be in deficit because the private sector wants to be in surplus. You can’t really get around that; the only choice is whether you choose what to spend money on or whether you get forced to spend money by the decline of the economy. I think that’s particularly true here because the automatic stabilisers [mechanisms that are triggered automatically and act to calm economic conditions, such as increased benefit payments as unemployment rises] are much stronger. This is versus the argument which says that you make your fiscal situation actively worse by trying to cut.

PK: The automatic stabilisers certainly mean that government spending may well rise even without any attempt. But you have to be really careful when people say that there has been no austerity because government spending has been going up. There are a lot of automatic stabilisers kicking in.

SF: In the eurozone context, the argument, say, between François Hollande and Angela Merkel ends up being a practical argument to her about what actually would do the most to reduce deficits.

PK: I have to say—I am not seeing any coherent economic argument from the Germans.

Bob Bischof (board member, the German-British Chamber of Industry and Commerce): They seem to be doing well though and that gives credibility.

PK: They’re arguing about how this thing is supposed to work out. I’m not hearing a story from them about how the periphery is ever supposed to exit from this crisis.

BB: You may have not noticed, in the metal-working industry, there’s a 4.5 per cent increase in wages and that’s a form of inflation, of trying to inflate the economy. You can’t do it with just fiscal means. You need to look at the supply side a lot more.

PK: During that long period when people thought that all eurozone bonds were safe, you had huge capital flows from Germany into the periphery [and] large rising relative wages and relative costs in the periphery. Now it has to be reversed. That’s not going to happen through wage cuts [in the periphery]: it’s almost impossible. So it has to happen through wage rises in Germany. There is some of that going on; we could use some more. A couple of days ago, I thought it sounded as if German authorities were starting to accept that there may have to be 3 to 4 per cent inflation for a while.

Rudolf Adam (deputy head of mission, German Embassy, London): I would like to draw your attention to the fact we have general elections in 2013 and so a significant rise in inflation right now might be suicidal for the incumbent government. If you start moving in the direction of eurobonds, then I think if you ask people behind closed doors, most people in Germany would say this is going to come. But we are not going to get it before the fiscal pact is signed. You can’t sell it to parliament. It is not a decision that is made by academics, it’s made by politicians.

PK: The very first experience of practical policy discussion I ever had was 36 years ago with a group of MIT grad students. We would talk about things going on and the answer to each one was “Well, that would be impossible!” It turned out there was no space that was possible. That’s the story of the eurozone: one of the things that was considered impossible is going to happen. I don’t think that we have until the 2013 elections in Germany [to find] a credible route out for the periphery.

RA: Then it’s a question of who pays, who carries the blame.

PK: Oh definitely! The parallels: I have a memory of meeting with [President Fernando] de la Rúa in Argentina in 2001 in the Pink House [the presidential residence]. He knew that [the economy] was going to collapse. But you cannot be the person to pull the plug. It had to happen through a banking crisis, and then a closure of banks. There are a bunch of stylised facts of what happens after devaluations and the one absolute consequence is that the finance minister loses his job.


John Plender (columnist, Financial Times): Could I talk about China? They have been pursuing an economic model where investment is a huge amount of GDP (around 50 per cent). That involves enormous misallocation of capital. The policy-making elite have said they are committed to re-balancing the economy towards consumption, which would be very helpful from a global point of view, but it’s clear they don’t know how to do it. How long do you think this can last? And how good a bedfellow is China going to be for the rest of us if the growth rate comes down?

PK: I’m a numbers guy. I try to sit down with the data and we know that all economic data are a boring form of science fiction. But the Chinese are more fictional than most. What’s actually happening in China—God knows! Just how long can you maintain a political system that is based on a completely pure hypocrisy: declare you are socialist and you’re actually running robber baron capitalism? How robust is that to a slowdown in the growth rate? I don’t know.

For the world economy, what matters is not Chinese GDP at purchasing power parity [when economies are compared by considering the money needed to buy the same goods or services] but Chinese GDP at prevailing exchange rates, which is roughly comparable to Japan. It’s not actually that big a player in the world economy yet. If there is political turmoil, who has any idea? The interesting thing is that I suspect that neither does the Chinese leadership really know what’s going on. They’re going off numbers reported from provinces by people who are mostly giving information they think the leadership wants to hear.

Shriti Vadera (former government minister, now consultant): What do you think the impact is on mainly Chinese-driven commodity prices on both the US and Europe? I also wanted to make two comments: one is that we’re a complete nation of NIMBYs and until we change the planning rules, we have nothing to invest in. The second is waiting for the German elections for the fiscal compact: by that time it’ll be completely clear to the Bundestag [parliament] that the compact will be honoured in the breach and I would like to know what they’d be voting for at that point.

PK: That’s right. And by the way, the US is not as NIMBY as the UK but we don’t need new projects now—we can get a substantial stimulus from re-hiring school teachers and filling the potholes. On commodity prices: they have been pushing headline inflation rates around a lot, but fears that an oil shock was going to derail growth don’t seem to have materialised; nor do we see a boost when commodity prices go down. We don’t have wage indexation any more so we don’t have those inflationary spirals. When [commodity prices are] rising, the inflationistas start speaking about [the] Weimar [Republic] just around the corner; when they’re falling, they stop talking about them until they rise again. I find it interesting how little it seems to have mattered that we have had these wild commodity price fluctuations.

Nick Carn (Carn Macro Advisors): A few years ago, people talked about the American baby boomers saving for their retirement. It didn’t happen according to that script. It’s been suggested that in the immediate aftermath of the crash the economy was in Keynesian conditions—what everyone needed was a bit of a cheer up to go and spend some money—but after that, you are looking at something different. You are looking at people who have a great deal of debt, haven’t thought much about their retirement, are beginning to wonder, quite rightly, whether the government is going to look after them. So you are under rather Ricardian conditions [where people spend less as governments cut spending]. I’m using these as horrible shorthands.

PK: Actually I think it’s the other way around. I don’t believe the problem with the US consumer is that people are frightened and they will only start spending when we have created confidence. I think people really do have excessive levels of debt. They need to pay those levels of debt down. You can’t have a consumer-driven recovery until that happens. We actually have corporate sectors that are in good financial shape but which see no reason to spend because of the lack of consumer demand. That is the answer to the question “How can more debt be a solution to existing debt?” It is not an endless process. The government support has to last only until household balance sheets have been sufficiently repaired that the government no longer has to play that role.

And we’re making progress in the US! There has been a significant reduction even in nominal household debt. A substantial part has been paid through defaults, but not all of it, and household incomes are rising slowly.

If we avoid doing something really stupid, I’m fairly optimistic for the medium-term in the US. We built no houses for five years. So we have, if anything, a housing shortfall. Household debt has been falling relative to income, so we should be in a position to have a private sector recovery given half the chance. But, not yet.

Bronwen Maddox: What do you think recent US figures say about the recovery? Despite the inadvertent austerity you described, is the economy recovering?

PK: Housing is still very vague. There is a roaring comeback in autos which is quite a remarkable thing driving the economy right now. The labour market: we have a little improvement. But it’s pretty glacial stuff. It’s not a roaring recovery.

Alice Enders (economist, Enders Analysis): As you know, the UK has had very high levels of inflation. Part of that is due to a VAT rise. But we’ve had a lot more inflation than you would expect with a significant output gap.

PK: The UK inflation numbers have been a puzzle. What I really want is a core inflation ex-indirect taxes number [an inflation figure from which VAT and other such charges are excluded].

AE: It’s high.

PK: But I thought it plunged quite a lot…

AE: It’s come down a lot, but it’s still constantly over-target.

PK: There is something odd about the numbers. There is an argument that wages are the core measure you should look at. Then, the UK looks identical to the US: substantial fall in wage growth that then levels out at 2 per cent [per annum] or a bit less. That was a surprise—one of the things I got wrong. I thought we would be into deflation territory by now and then wages would be flat or falling in the US and they are not. It turns out that there really is downward nominal rigidity [a reluctance to cut pay]. The aggregate US wage figure is the combination of some people getting increases and a lot of people getting precisely zero. It’s an amazing chart. I don’t know if there is any comparable evidence in the UK, but I wouldn’t be surprised.

Rudi Bogni: If your main scenario—even short of Democrats taking Congress again and implementing all your policies—were to come true and your view on the eurozone is correct, then the euro should be substantially lower today. But the market doesn’t think that it’s going to be so much in the direction you point out.

PK: The question I always ask about the value of the euro is: where is the margin of arbitrage? When somebody is making a decision that’s effectively going to determine the value of the euro against the dollar, what are they arbitraging? If it’s essentially bonds versus treasuries and I’m not clear if that’s a slam-dunk. If you think that the Germans are, in the end, going to refuse to do inflation then you’re looking at a breakup in the eurozone, in which case your euros turn into new deutschmarks and those could shoot up in value. Even if you are arbitraging Greek debt and Spanish debt, there are pretty bad prospects but you are being rewarded by high interest rates. So, it’s not clear to me that the woes of the eurozone imply that the euro should be a lot weaker.

I do see these things saying the euro needs to be depreciated so that you can have an export surplus for Europe. The last time I saw Jim Tobin [Nobel laureate famous for proposing a tax on financial transactions] before he died, he said at any given time always have a clear view where the currencies in the world should move. At that point, around 2001 or so or 2002, his clear conclusion was that all the main currencies needed to devalue against each other. And basically, that’s what we’re at right now.

Samuel Brittan (economic commentator, FT): When last I saw you, you thought [George W] Bush would give you plenty of material to get your teeth into. What do you make of Obama’s economic policy? Also, why do we allow Keynesian views to be represented entirely in terms of public spending and public works? As I understand it, tax cuts are equally desirable and the exact mixture depends on which cuts.

PK: Providentially as Bush went out, we went into a horrific crisis, which was from a personal point of view, perfect. I spent my whole life preparing for that crisis.

On the tax cuts issue: I think Friedman was right—temporary cuts are going to be largely saved. That means that they are not very good counter-cyclical policy. If you can target the funds on people who are likely to be liquidity constrained [short of ready money], they are more likely to work. It will look more like emergency aid.

If you actually look at the Obama stimulus, such as it was, there are some tax cuts, there was some effort to make work pay and to target that toward people on lower incomes. There was very little [on] infrastructure—$100bn—and it’s largely invisible. Once in a while, you pass road works or a train station and see some sign saying “We are replacing the lighting fixtures with money from the Recovery Act,” but part of the problem is that people don’t see it.

Early on, John Taylor [the Stanford University economist] argued that “we need a tax cut and it needs to be permanent or it would be largely saved”. My response was “so you would cut taxes permanently every time the economy turns down—doesn’t this ratchet us down to having no revenue?”

Peter Jay (former BBC economics editor and ambassador to the US): If the objection to temporary tax cuts is that a lot of it would be saved, the answer is surely to have more of it! The attraction of the “tax holiday” is that it is, by definition, self-reversing. As the economy recovers, you don’t have to go to parliament or Congress to raise taxes if the holiday comes to an end. Meanwhile, you can give this powerful boost to demand. If you think half of it will be saved, then double the amount involved.

PK: Well, back last fall, the Obama administration came back with Stimulus 2, which was purely raising the flag—we knew there was no chance—and it was a temporary payroll tax cut. You might have said, “Republicans support tax cuts, so they would support that?” Yeah, right! It turns out they are only in favour of tax cuts for the one per cent.

PJ: But that’s their problem. We can pay.

PK: Sure. A temporary VAT cut is not the ideal, but if that’s what you think you can get—okay. If [the Democrats regain control of the House] and if the Obama people decide that all they can do is temporary tax cuts, I will support it. But Keynesianism has not been discredited because of the identification with public investment. It’s much deeper than that. It’s a forty-plus year campaign. You have to give it to the American Right—they play a very long game.

The roundtable, chaired by Bronwen Maddox, was also attended by: Robert Chote, chairman, Office for Budget Responsibility; Clive Cowdery, chairman, Resolution Foundation; Andrew Haldenby, director, Reform; Paul Johnson, director, Institute of Fiscal Studies; Gavin Kelly, chief executive, Resolution Foundation.

The transcript was edited and supplemented by James Elwes, Prospect’s deputy editor.


Critics of the Keynesian cure

Paul Krugman argues that the prime cause of the slump is a collapse in demand, caused by too much money saved and not enough spent. The cure, he says, is for governments to spend on big projects. In order to spend, governments may have to borrow more.
There are three sorts of riposte (although some prominent figures, wary of Krugman’s famous combativeness, now pointedly do not rebut him by name). Niall Ferguson (left), the historian, among others, argues that you don’t cure a problem of debt with more debt. In May, Ferguson told the BBC that when the present government came to power, “British public finances were about the worst in the world… we had the biggest debt mountain after Japan. The idea that there was some Keynesian option open to David Cameron is just completely fantastic.” Krugman’s answer is that when growth returns, debt can melt away quickly, as the years of Bill Clinton showed, particularly when helped by inflation.

A second challenge is that his prescription, even if good for the US, does not apply to much smaller economies, more vulnerable to the markets’ scepticism that they can service their debt. He sidesteps that challenge, acknowledging the severity of the eurozone problems. But he argues that for the UK, at least, there is no excuse, calling the Cameron-Osborne austerity package “the greatest unforced error.” However many think he dismisses too quickly Osborne’s case that the markets would not long tolerate Britain’s deficit without signs of energetic attempts to reduce it. Here, the argument often degenerates into “yes the markets would”—“no they wouldn’t.”

A third angle of attack is a subtler version of the first, put eloquently by Raghuram Rajan (left), the University of Chicago economist. In a recent Financial Times article, Rajan recognised two reasons for spending now, when the benefit might outweigh the burden of the extra debt. The first was financial panic, of the kind besetting Greece (although, he argued, no other countries); the second was the damage done by long term unemployment, which causes workers to lose skills. But he points to Japan as evidence that the value of infrastructure spending is often overstated, and argues that the real cause of lack of growth is developed economies’ loss of the ability to make things the world wants. “The key question then is whether more government spending can make a real difference to the most severe employment problems,” he commented. “Here the case for a general stimulus becomes less compelling.”

The US is now recovering, if fitfully, but both sides in this debate appropriate this evidence to their cause: Krugman and company to say that it should be doing so even faster, and critics to say that his prescriptions are redundant.


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