Macroeconomics in small economies
By Scott Sumner
Like many American economists, I’ve learned macroeconomics from an American perspective. But America is a very unusual country. For instance, US RGDP growth has averaged about 3% for the past 120 years, if not more. Most business cycles are fairly small, partly reflecting the fact that our economy is well diversified. If Nevada is in recession, Massachusetts may be growing, or vice versa.
Other economies don’t seem to adhere as closely to a stable trend line. Japan did very poorly in the 1940s, then raced ahead for decades, and has seen little growth since the early 1990s. Even smaller economies such as Latvia, Estonia, Iceland and Greece have seen spectacular booms followed by huge busts.
In the following quotation, I believe Paul Krugman is wrongly applying American-style macro thinking to the Greek case:
But doesn’t the ultimate cause lie in wild irresponsibility on the part of the Greek government? I’ve been looking back at the numbers, readily available from the IMF, and what strikes me is how relatively mild Greek fiscal problems looked on the eve of crisis.
In 2007, Greece had public debt of slightly more than 100 percent of GDP — high, but not out of line with levels that many countries including, for example, the UK have carried for decades and even generations at a stretch. It had a budget deficit of about 7 percent of GDP. If we think that normal times involve 2 percent growth and 2 percent inflation, a deficit of 4 percent of GDP would be consistent with a stable debt/GDP ratio; so the fiscal gap was around 3 points, not trivial but hardly something that should have been impossible to close.
America would be able to support a public debt equal to 100% of GDP. But unlike Krugman, I believe the Greek situation in 2007 was “wildly irresponsible.” Greece needed to run budget surpluses during the boom years, so that it would have the resources to do fiscal stimulus during a depression. Instead they ran a very large budget deficit during the boom period.
By the way, notice that Krugman simply uses the actual budget deficit, not the cyclically adjusted (structural) deficit, which presumably was even worse. In contrast, when economies are depressed he tends to use the cyclical adjusted deficit, which makes policy look more contractionary than the raw figures would suggest. Here is his excuse:
Now, the IMF says that the structural deficit was much larger — but this reflects its estimate that the Greek economy was operating 10 percent above capacity, which I don’t believe for a minute. (The problem here is the way standard methods for estimating potential output cause any large slump to propagate back into a reinterpretation of history, interpreting the past as an unsustainable boom.)
I would certainly not believe a 10% over capacity estimate for the US economy in 2007, but I don’t find it all that implausible for Greece. Suppose your economy is sucking in lots of foreign workers for a real estate boom. The boom ends and the foreign workers leave. Now your “natural rate of output” is lower, as you have less labor. The outflow of Mexican labor after 2007 was not enough to cause a big drop in the US natural rate, but in a smaller economy like Greece, or Nevada, or Dubai, that sort of shock to capacity output could be much more significant.
In the 1999-2000 boom the US government did run a budget surplus, and I believe Krugman supported that policy. He once suggested that President Bush made a mistake by cutting taxes and putting us back into a structural deficit. I’d argue the same applies to Greece (and Iceland, Estonia, etc.). Countries with those sorts of wild swings between boom and bust need to run surpluses during the good years. Because Greece did not do so, it is now forced to beg for loans from others. Its creditors know that it is unlikely to be able to repay those loans, and not surprisingly are reluctant to grant even more loans without some pretty strict conditions attached.
I recall that Australia went into the Global Financial Crisis with a net debt of less than 10% of GDP. If Greece had done the same it would be far better off today. (Sometimes the VSPs worries about public debt are actually true.)
I do agree with Krugman’s conclusion:
The euro straitjacket, plus inadequately expansionary monetary policy within the eurozone, are the obvious culprits. But that, surely, is the deep question here. If Europe as currently organized can turn medium-sized fiscal failings into this kind of nightmare, the system is fundamentally unworkable.
Yes, but for better or worse the Europeans are strongly committed to the euro. Even the Greek public is strongly committed. So Europe needs to make the system work better. And that means radical reductions in debt, back to levels where there is room to do fiscal stimulus during deep downturns. And that also means a move towards much more neoliberal policies, to make labor markets more flexible. And that also means the ECB needs to switch to a policy that stabilizes aggregate demand for the entire eurozone, such as NGDP targeting. All of these things need to be done, and if they are done then the euro may be able to work tolerably well. But I’m not optimistic that these things will be done, which is why I still think the euro is a bad idea.
What about fiscal union? That would require political union, turning the eurozone into a single country. It’s not likely to happen and I believe it would be unwise.