Forex Blog

June 30, 2010

Krugman Uses the “D” Word

It has only been two days since the wrap-up of the G20 meeting, but already, second-guessing has shifted into high gear. Two statements in particular caught the attention of the markets; the first of these, officially removed the concept of a global “bank tax” off the table. The second, put forward a timeline for reducing government stimulus spending.

The axing of a coordinated bank tax came as no surprise. It was clear that some countries wanted to move forward on charging a levy, while others were vehemently against it. As it stands now, individual countries will act as they see fit. The agreement around spending and deficits on the other hand, presents a far more interesting story line; interesting because some big names are lining up publically to trash the idea.

In his article published earlier this week in the New York Times, economist Paul Krugman argued the point that this is the worst possible time to worry about deficits. In his view, moving too quickly from undisciplined spend-thrifts (my words) to fiscally-responsible penny-pinchers (again, my words), is the very formula that led to the depression of the 1930s. Krugman believes that failing to maintain spending levels, can only result in one outcome.

“We are now, I fear, in the early stages of a third depression,” writes Krugman, a depression brought about by a “failure of policy”.

Seriously? A depression?

According to Krugman, there have been two previous depressions. One in the 1870s, and the “Great Depression” of the 1930s. Krugman believes we are following the same path that preceded the last depression. So, at the risk of oversimplifying the causes of the last depression, let’s look at the major contributors that brought about the depression, and look for commonality with today’s situation:

1. Loss of Market Valuation and Bank Failures

As the stock market lost value – approximately $40 billion within the two months following the so-called “Great Crash” – a series of bank failures were triggered. Even by today’s standards, $40 billion is a lot of cash – imagine what it meant to the economy in 1930 when US GDP was just over $91 billion.

2. Decline in Public and Government Spending

Naturally, a loss equal to about 43 percent of the country’s total yearly GDP, resulted in severe deflation. The lower demand for goods and services had a devastating impact on employment, and as more people found themselves out of work, spending fell even further.

3. American Economic Policy

In order to protect businesses in America’s important manufacturing sector, the government introduced the Smoot-Hawley Tariff in 1930. The intent was to impose duties on imported goods in a bid to make US products more attractive for domestic consumers. As should have been predicted, other countries retaliated with similar tariffs, making American goods less competitive globally. The domestic market lacked the capacity to pick up the slack of the lost foreign sales, reducing further, overall demand.

The common theme these three contributing factors share is that they all lead to reduced spending. In his book “Essays on the Great Depression”, Bernanke placed much of the blame for the depression on economic policy that neglected to protect failing banks, while at the same time, allowing the supply of money and credit to contract.

Despite the public backlash sure to follow, Bernanke was not about to allow the same thing under his watch. Banks were rescued and stimulus money was spent. Given his recent remarks committed to the continuance of an expansionary policy, it is obvious that Bernanke and Krugman are in agreement that governments must continue to support the recovery.

After Years of Spending, Why the Sudden Swing Now to Deficit Cutting?

Of course, not everyone agrees with this approach. Several countries in Europe find themselves face to face with out-of-control deficits. Spooked by the sovereign debt crisis in Europe, Germany, and most recently Great Britain, have opted to follow a self-imposed austerity path to reduce government debt. Germany’s budget last month, includes 80 billion euros (US$107 billion) in spending cuts, while the David Cameron-led coalition in Britain, has also announced significant spending reductions as well as steep tax increases.

I don’t believe anyone an argue against the need to reign in deficits; rather, I think it is the timing that concerns critics. Certainly, countries cannot continue to rack up massive deficits each year, but nor is it to anyone’s advantage to choke off a recovery before it has chance to gain greater traction. This would, to use Krugman’s words, be a “failure of policy”.

“Around the world”, notes Krugnam, “most recently at last weekend’s deeply discouraging G20 meeting – governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.”

In the end, a compromise was reached that enabled all the G8 countries, with the exception of Japan, to find language they could support. The solution proposed by Canadian Prime Minister Stephen Harper, and supported by President Obama, called for a continuation of the planned stimulus spending in the short-term, with a longer-term goal of reducing deficits by 50 percent within three years.

It is hoped I’m sure, that the pledge to maintain spending to be followed by deficit cutting later on, sends a positive message to the markets. However, I fear that what is still missing, is a stronger commitment to a coordinated approach to ensuring sufficient stimulus over the next six to eight months.

The UK has already passed a budget to reduce spending, as has Germany. Greece has had austerity measures forced upon it in exchange for receiving emergency funding, thereby setting a precedent for other EU countries like Spain and Portugal on the brink of needing their own emergency bail-out. No matter what was promised in Toronto, it appears that Europe is determined to scale back on spending.

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