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.

On Debt Talks, a Lose-Lose-Lose-Lose Situation

1:07 p.m. | Updated with a fifth (less likely) scenario.

Almost whatever happens this week with Washington’s debt talks, the economy will most likely be worse off.

As Dean Maki, the chief United States economist at Barclays Capital, put it: “The basic issue is that the U.S. is on an unsustainable fiscal track, which is pretty widely agreed upon. From that point, none of the choices are fun.”

CATHERINE RAMPELL

Dollars to doughnuts.

Here are the likely scenarios I see:

Dollars to doughnuts.

1) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. As a result, the Treasury stops paying debts it owes.

If that happens, the rating agencies downgrade the United States’ debt. The cost of borrowing for the United States government shoots up, since lenders demand higher interest rates from borrowers that are less trustworthy. Many other interest rates are pegged to the cost for the United States to borrow, making interest rates on all sorts of other loans, like mortgages, rise too. Credit markets freeze up, crushing an already-feeble economic recovery.

Macroeconomic Advisers predicts that failing to raise the debt ceiling in time — even if the delay is only one month — will very likely result in a new recession. And because it’s more expensive for the United States to borrow, the United States debt gets even larger, the exact opposite effect from what fiscal hawks are hoping for.

2) Held up by disputes over how to reduce deficits, Washington doesn’t raise the debt ceiling in time. But rather than default on its debt, it diverts money from other spending into paying back bondholders.

That could mean that Social Security checks are not sent, soldiers in Afghanistan and Iraq are not paid, and all sorts of other consequences.

In addition, bond markets might still freak out because the threat of default remains, so interest rates could rise anyway and cause all the terrible consequences in Scenario No. 1 (potential second recession and even bigger federal debt).

3) Washington comes up with a deal to raise the debt ceiling, but it amounts to less than $4 trillion in savings.

Standard & Poor’s has said that just raising the debt ceiling is not enough; without a “credible” plan for at least $4 trillion in savings, the United States might still have its credit rating downgraded. That could, again, mean higher interest rates and all the other terrible consequences of Scenario No. 1.

4) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings over a near-term horizon.

The credit rating agencies are appeased, but such severe austerity measures put the fragile economic recovery at risk. The states in particular are anxious about what major spending cuts mean for them and for the many social safety net services they provide with federal support.

As Bruce Bartlett and others have written, similar fiscal tightening during a fragile economy happened in 1937. Those actions resulted in a severe second recession and prolonging of the Great Depression, partly because it was coincident with monetary tightening as well. While a sharp, sudden monetary tightening seems unlikely, the Fed is at the very least pulling back on its easy monetary policy with the end of its second round of quantitative easing.

As The Wall Street Journal’s Kelly Evans observed, Japan had a similar experience in 1998, when austerity measures were followed by a recession and a widespread sell-off of Japanese bonds.

And even if these likely American austerity measures don’t result in an outright recession, job growth is already so feeble that most Americans still think we’re in recession.

Imagine how terrible things would feel if the economy slowed down even further.

5) Washington comes up with a deal to raise the debt ceiling that amounts to more than $4 trillion in savings, but over a longer-term horizon.

This is the best-case scenario: It deals with the long-term unsustainability of the country’s fiscal arrangements — which is good for growth in the long run — but doesn’t rock the boat in the current economic recovery.

Unfortunately, it also seems to be the scenario that is least likely to be pulled off effectively.

Economists want spending cuts and/or tax increases that come after 2012, when the economy is expected to be stronger. But to use Standard & Poor’s lingo, cuts that take effect in 2012 may not be fully “credible.” Committing to future cuts/tax increases is just another way of kicking the can down the road, as Washington has been doing for decades now. Almost every time Congress promises painful fiscal measures at some future date, later politicians jump in to dismantle them just before they take effect.

“We do seem to have a time-consistency problem,” Mr. Maki said. “There does never seem to be a good time for major cuts, and they’re not going to be more popular five years from now versus now.”

He says that Congress must come up with a way to prove that these are cuts that will actually happen, versus something that’s on the drawing board and is therefore erasable.

Unfortunately, he says, “There is no way to completely tie the hands of future legislators.”