Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 18 May 2014

Keynesian economics works: Eurozone edition

Paul Krugman is fond of saying that since the financial crisis, basic Keynesian economics has performed pretty well. Increases in government debt did not lead to rising interest rates. Increases in the monetary base (QE) did not lead to rapid inflation. But these are not the only places where Keynesian economics works. Keynesian analysis tells us almost all we need to know to understand what has happened to the Eurozone since its formation.

Some people are fond of denouncing mainstream economics because it failed to predict the financial crisis. But the nature of the Euro crisis was predicted by standard Keynesian open economy macro. The big problem with a monetary union was that countries could be hit by asymmetric shocks, and would no longer have their own monetary policy to deal with them. Many economists, myself included, said that this problem needed to be tackled by an active countercyclical fiscal policy - again standard Keynesian analysis. This advice was ignored.

What those using Keynesian analysis did not predict was the shock that would reveal all this: that the financial markets would make the mistake of assuming country specific risk on government borrowing had disappeared once the Euro was formed, which helped lead to a substantial and rapid fall in interest rates in the periphery. But once that happened, Keynesian economics tells the rest of the story. This large monetary stimulus led to excess demand in the periphery relative to the core. This in turn raised periphery inflation relative to the core, leading to a steady deterioration in competitiveness.

This boom in the periphery was not offset by fiscal contraction. Instead the public finances looked good, because that is what a boom does, and the focus of the Stability and Growth Pact on deficits meant that there was no pressure on politicians to tighten fiscal policy. Eventually the decline in competitiveness would bring the boom to an end, but a standard feature of quantitative Keynesian analysis is that this corrective process can take some time, if it is fighting against powerful expansionary forces.

So Keynesian economics said this would end in tears, and it did. The precise nature of the tears is to some extent a detail. (If you think the Eurozone crisis was all about fiscal profligacy rather than private sector excess, you are sadly misinformed.) Of course Keynesian economics could not have predicted the perverse reaction to the crisis when it came: austerity in the core as well as the periphery. It could not have predicted it because it was so obviously stupid given a Keynesian framework. But when general austerity came, from 2010 onwards, the implications of Keynesian analysis were clear. Sure enough in 2012 we had the second Eurozone recession, helped along by some perverse monetary policy decisions.

Paul Krugman also tends to note how most of those who bet against Keynesian predictions on interest rates and inflation after 2009 have yet to concede they were wrong, and Keynesian analysis was right. The bad news from the Eurozone is that this kind of denial can go on for fifteen years (and counting)! But there is a reason why we teach Keynesian economics - it works.   


  1. The stumbling of the Eurozone has also led to great political problems: it is the only real example of a larger monetary union that has sought to temper the jingoistic feelings in various nations.

    There is a feeling that for Russia under Putin, say, China with the partial opening of its economy whilst continuing to crush free speech and democracy, has become a more telling dictatorship-through-growth model than the Euro's more democratic route, or at least the European Union with or without the Euro.

    Of course, China's economy may go into troubles any day now, but that's no excuse for the Euro not to fix its preventable problems.

    (Oh, and a BBC aside: the Beeb is reporting today on Carney's housing bubble comments; the same BBC that's still running those dreadful estate agent TV home selling shows).

  2. Utterly agree to the point, what has caused the huge gap in competitiveness between the periphery and the core.

    The gap competitiveness has arisen due to the German wage-dumping policy from the start of the monetary union.

    Unit labor costs in Germany have been declining from the introduction of the euro, while they have risen in the rest of the Eurozone.

    Germany is undercutting the inflation target of the ECB for more than ten years.

    Is monetary union primary not an agreement on a common inflation target?

    I am therefore of the opinion that it weren’t the capital flows within the EMU, but the persistence divergences of unit labor costs (which are the most crucial determinant of inflation) the cause of the gap in competitiveness in the Eurozone.

    1. It wasn't only Germany that had declining unit labour costs. Finland as well as Austria and Ireland performed similar, while Greece, Spain and Italy were remarkably above the average of the EU. Only France was close to the average.

  3. I hate to think what kind of crisis would cause the anti-Keynesians to admit their error(s). It would have to be catastrophic, with millions out of work for years and years, dramatic increase in the number of poor people around the world, enormous inequality and mounting, irrational behavior and beliefs spreading among major institutions, including university economics depts. and central banks, etc. And yet, hard to believe, I doubt that even then few would have the fortitude to admit their mistakes and change their ways. Eventually ( five years out? a decade from now?), things will improve. I think Keynes would ascribe such "recovery" to our "animal spirits" re-asserting themselves, and to a growing general feeling that we have punished ourselves enough. Still, the anti-Keynesians will claim a great victory. See? We knew that victimizing the victims would win the day!

  4. Regarding that last paragraph. The Wall Streeters who signed that anti-QE open letter have usually either changed or modified their views. Having skin in the game tends to do that.

    The letter signers who have not recanted are the Republican operatives and pundits. They don't have skin in the game of high finance, but they do have skin in the political game.

    Then there's a third mixed group (academics etc) of whom some changed their minds, some not.

    What Krugman overlooks is that it won't become headline news when somebody changes his mind over QE. Hence it's unlikely you'll ever learn whether somebody has changed his mind, unless you take an active stance and google these persons to find out what they think nowadays.

  5. If Mr. Wren-Lewis were really serious about helping the eurozone, then he would be campaigning full out for the UK to leave the EU. The only way forward for the euro is greater fiscal and political integration in the eurozone, and the easiest way to do that is to make the EU equivalent to the eurozone. So non-euro EU countries either need to adopt the euro or to leave.

  6. "Paul Krugman also tends to note how most of those who bet against Keynesian predictions on interest rates and inflation after 2009 have yet to concede they were wrong, and Keynesian analysis was right."

    And except for maybe Stiglitz, I have yet to see a macroeconomist who favoured QE and a lowering of rates admit that it has increased inequality. Funny that.

    1. Krugman and others have pointed out that increased inflation would help cope with existing debt, which would be a boon for people with mortgages and car loans etc. However, as Krugman constantly points out in his calls for more inflation, QE has failed to boost inflation much and so the effect has been modest (though better than in the Euro-zone).

      However, QE is a rather indirect means of dealing with debt, and it would have been more efficient to set up other programs, such as forcing rescued banks to accept haircuts on mortgages. Unfortunately, when you have people like Geithner shoot down such proposals on grounds of "fairness" you get nowhere fast.

      (For "fairness" read Republican talking point on deadbeat homeowners getting rewarded for irresponsible borrowing).

  7. Everything you say is right, but the institutional set up by the Maastricht Treaty did and does not allow for a Keynsian policy. You know this, so does everyone in Europe. But the longer the crisis lasts, and disillusion with the European project increases, the less likely it becomes that Europe will be able to pull itself together to repair short shortcomings of the euro zone as now constructed. I felt that your article was right, but irrelevant. Reaching for another tranquiliser.....

  8. Simon,

    I agree that Keynsianism works. As you probably know, Scott Sumner is one of the world's leading opponents of Keynsianism. Personally I think he has lost the plot. But I'd be interested so see you analysing his ideas.

  9. Keynesian economics works in Europe? Really? Two small countries: one in euro and one totally outside EU. 'Austerity, fixed currency' Estonia per cap real GDP in 2007 was 9.8bn (national currency) and in 2014 it is forecast at 9.8bn (IMF database).
    While 'Keynesian' Iceland with devaluation and free currency was in 2007 per cap real GDP 3.0bn (national currency) and is now forecast for 2014: 2.9bn! So Estonia is about the same after seven years and Iceland is still down 5%. Both austerity and Keynesian policies failed.

    1. I think you will find that Iceland had another small problem over this period!

    2. Iceland defaulted, Estonia did not. Default was Simon Wren-Lewis' recommendation for periphery countries. So I do not think he has a valid objection to Michael Roberts.

  10. What did kill the economies in most troubled countries were housing bubbles. It seems to me you don't need Keynesian economics to explain how devastating housing bubbles are.
    It's also not a given fact the euro would lead to housing bubbles, as for example Italy did not have one, while several countries outside the eurozone did have housing bubbles.
    You may call austerity perverse, but what was the alternative when several of the periphery countries couldn't borrow? Whatever policy would have been chosen, there is no guarantee some eurozone countries can stay within the eurozone. How is fiscal stimulus going to improve their competitiveness? Let's wait and see until some of the periphery countries hit the 200% of GDP debt limit if the markets still have confidence in these countries. What the world needs is less economists fighting economic dogma, but more on how to prevent boom bust cycles as that's the issue to solve. The best way to get out of this mess is to not get into this mess in the first place.

    1. "...what was the alternative (to austerity) when several of the periphery countries couldn't borrow?"

      Excellent point. Could Simon Wren-Lewis answer?

    2. Oh, I don't think anyone thinks that the worst hit periphery countries had much alternative once the debt crisis arose, especially given the most unhelpful attitude of their creditors. The issue is about what they should have been doing before it, and what the NON-periphery countries should have been doing after it.

  11. Periphery should have consolidated their budgets, although not in so extreme way. Or, expansion aimed at creating GDP. Somewhat of consensus among those who calculate ratio of government spending and GDP is that 1% of GDP reduction in government spending results in 1.5% reduction in GDP. So, expansion aimed at creating jobs would increase GDP more than deficit, meaning deficit/GDP falls (we are talking about levels close to 100%). Increased GDP means more taxes, which reduces deficit. So, clever New Deal type expansion can result in financial stabilization.
    Even if periphery had to contract, strong expansion among core countries, those who most underperformed inflation in the previous decade, starting with Germany, would increase competitiveness of the periphery, also resulting in easier stabilization.
    As for access to capital, if ECB has decided to act like central bank in any state would, as lender of last resort, every Euro country would have almost unlimited access to capital at low interest rates. But core, especially Germany, wouldn't hear about it.

    1. ''expansion aimed at creating jobs'':
      I hope you don't mean like Greece, with even more government jobs.
      ''new deal type of expansion''
      Maybe that would work for US with lack of infrastructure investments, but Southern Europe just has had a decade of (EU subsidized) infrastructure spending, if you travel through these countries you will notice public infrastructure is pretty good. So what kind of new deal spending do you have in mind?
      ''strong expansion among core countries''
      it's not in the DNA of Northern countries to do large fiscal spending (they already have mixed economies), economies do compete with each other, expansion in one country to help an another is not realistic, decreasing competitiveness of Germany does not make periphery more competitive compared to outside eurozone
      ''ecb has decided to act like central bank in any state would as lender of last resort''
      Translation: Germany needs to take on more risks. EU is not a state, ECB is not like other central banks
      ''but core especially Germany wouldn't want to hear about it'' I
      think it's perfectly understandable German is not going to take more risk than is in their own interest.Lisbon treaty has a no bailout clause, all countries knew what they signed up to.

    2. Expansion aimed at creating jobs could be realized through tax credits or even direct money transfer to job creators, for example, employer gets back 50% (60%, 70%...) of all expenses for a newly created workplace, if he keeps that workplace and doesn't downsize others for 2 or 3 years (pension payments, all social payments, taxes).
      New deal type of expansion does not mean that kind of projects, it means that kind of investment. For example, finance PV factory in the country and then finance putting PV panels on every private roof in the country. Lots of people would be needed to put them, and people would get cheap subsidized electricity. While solar energy is still expensive and this wouldn't be cost-efficient in any way, in this economy, simply putting money into balloon and shoveling it down at the people wouldn't have worse effect than austerity.
      Interest rates for PIIGS fell substantially as soon as ECB indicated that they would actually make sure that no country runs out of money.
      Germany (and other core countries) used several years before crisis to gain large competitive advantage over periphery by running very low inflation and allowing high inflation in periphery. Maastricht criteria were meant to ensure that all the economies in Eurozone are in similar position. Germany improved its position compared to periphery by some 30 or so percent by keeping way below-target inflation and running high inflation in periphery. Now Germany wants to keep its low inflation, and force the periphery to do 30 percent internal devaluation. Fair solution would be for Germany to run 5 - 6 percent inflation for several years, until inflation in periphery rises naturally, when the whole Eurozone could go back to 2% goal.
      When countries transferred sovereignty of their central banks to the ECB, ECB should have acted in the best interests of the whole Eurozone. But it acts only in the interests of Germany.

    3. ECB did indeed calm the markets ... for now.
      Germany did what it always does: control inflation, control wage rises & structural reforms to become more competitive. You make it sound as if they were cheating, but this is what successful mixed economies do. Germany was called the sick man of Europe at that time, no wonder they tried to improve their competitiveness.
      Moreover, exports to the periphery are only minor compared to other countries in and outside eurozone, there was no deliberate policy against the periphery.
      The only thing you can claim is that moderate wage rises are now not in the interest of German workers, but that's up to the German voters to decide.
      The fact that some Southern European countries lived beyond their means or stimulated housing bubbles, causing some inflation, is not the fault of Germany. Housing bubbles can be controlled, not all (deficit) eurozone countries had them.
      The sad truth is some countries did blow up their economies, they only have themselves to blame for this.
      Expecting other countries to accept 5-6% inflation to bail them out is not realistic, just try to explain this to voters in Northern Europe. I am certain they rather leave the eurozone than accepting such a policy.
      ECB might be modelled after German bundesbank, but that was no secret. All countries who signed up to the euro knew what kind of central bank they would get, but some did not adjust their economic policies. They believed the hype of their own housing bubble fueled economies and forgot they can't adjust competitiveness anymore with devaluation. Again, the idea that Northern Europe should accept higher inflation to bail them out is politically simply not feasible, this has little to do with the ECB but with Northern European voters. Just try to explain your ideas to them instead of the ECB.

  12. "Of course Keynesian economics could not have predicted the perverse reaction to the crisis when it came"

    This political ignorance of purely technical Keynesianism is, as Kalecki has pointed out long ago, its main weakness. In other words, technically sound economics is politically infeasible (all the OId Keynesians lived in the social democratic post WWII era so they did not have to worry about political feasibility).


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