Paul Krugman and Cameron’s realism

I rarely write about this poor and benighted, yet still free, isle.

But Paul Krugman’s latest attack on the Government’s austerity policy – "Cameron’s Fantasy" – cannot go unchallenged.

He ridicules Cameron’s claim that fiscal discipline has brought down British borrowing costs and averted a debt crisis, more or less depicting him as clueless.

I happen to be a Krugman fan, not least because it is a delight to see a great economic mind at work – in real time, so to speak. He deserved to win the Nobel Prize, and he has been largely right about the shape of our global economic crisis over the last four years.

However, he is wrong about the specific case of Britain.

He displays this chart to show that US bond yields have fallen even further than gilt yields, and to show that they are doing so for deep structural reasons.

It is a false comparison. Britain is not the world’s paramount strategic and reserve currency power. It does not have latitude to trifle with global markets.

(Yes, I know, Japanese, German, Swedish and Danish yields are also falling, but these countries have large current account surpluses. The three Europeans are fiscal saints. Japan is still the world’s top creditor, with nearly $3 trillion in net assets.)

There was a horrible moment in the weeks leading up to the elections last year when it became clear that the vigilantes were indeed waiting to pounce on Britain.

This is a news piece I wrote at the time, citing the Unicredit team, and Unicredit was not alone.

"I am becoming convinced that Great Britain is the next country that is going to be pummelled by investors," said Kornelius Purps, Unicredit's fixed income director.

Mr Purps said the UK had been cushioned at first by low debt levels, but the pace of deterioration has been so extreme that the country can no longer count on market tolerance: "Britain’s AAA-rating is highly at risk. The budget deficit is huge at 13pc of GDP and investors are not happy. There will have to be absolute cuts in public salaries or pay, but nobody is talking about that.

"Sterling is going to fall further over coming months. I am not expecting a crash of the gilts market, but we may see a further rise in spreads of 30 to 50 basis points."

That was the mood in March 2010. The spreads were ballooning out to worrying levels.

Britain has won a reprieve because the Coalition has held rock solid and stuck to its policies. Perhaps there might be some safe margin for loosening now, but not much.

There was of course never any danger of a Greek/Irish/Portuguese outcome, given the Bank of England’s willingness to backstop the system with QE equal to 19pc of GDP).

However there was a risk of yields creeping up to Spanish levels and also something very familiar to Treasury mandarins, a disorderly flight from sterling. (As opposed to the orderly fall we have had, and which has been a lifesaver for parts of manufacturing industry.)

Needless to say, we can never prove this either way.

Britain has rescued itself twice over the last century by a radical mix of fiscal tightening on the one hand and monetary stimulus with devaluation on the other. We did it in 1931-1932 after liberation from the Gold Standard, and we did it again in 1992-1993 after liberation for the Europe’s Exchange Rate Mechanism (when Cameron had a ring-side seat as an aide to Chancellor Norman Lamont).

The trick worked both times. We largely avoided the Great Depression. We outperformed in the 1990s.

One can see why Professor Krugman dislikes this argument. It would question the primacy of Keynesian fiscal policy.

Perhaps fiscal policy is less potent than claimed. Or perhaps there is something specific about Britain, evidence that economics is really a subset of anthropology.

David Cameron is running Britain, not the United States, Germany, or Japan. We are a nation of flat-footed and humble shopkeepers over here. We don’t like theory. We like only realism.