Stephen King: Austerity can be postponed by a fiscal stimulus – but it can't be avoided altogether

Some of you may have been following the "austerity versus stimulus" debate in the Financial Times. Certainly, Paul Krugman has. The Nobel Laureate has been firing off all sorts of comments on his New York Times blogsite, "The Conscience of a Liberal", in response to those views he finds particularly abhorrent. Ken Rogoff, the joint author of the excellent This Time Is Different, has been one victim. Another has been Jean-Claude Trichet, the president of the European Central Bank, whose preference for fiscal belt-tightening has been met with the full force of Mr Krugman's Keynesian ridicule. In response to Mr Trichet's claim that "consolidation is a must", Mr Krugman offered the following broadside:

"Ask yourself, what evidence does he present ...? None, because the reality is that bond markets don't look at all worried ... So what are we to rely on for his definitive judgement that "consolidation is a must"? His "understanding" that "confidence is potentially at stake". This is a basis for a policy that affects hundreds of millions of workers?"

And earlier, in response to Mr Rogoff's claims, Mr Krugman offered the following thought: "... at current interest rates, a trillion dollars of [government] spending [in the US] would add at most around 0.1 per cent of GDP in real interest payments, and might actually improve the long-run budget position if a stronger economy now means less long-run damage".

Daring to criticise Mr Krugman is a very dangerous game, but I'm afraid to say that, on this occasion, his opinions don't really stack up. His mistakes relate, in part, to his observations on interest rates. He seems to think that (i) low government interest rates are here to stay, thereby ruling out a Greek-style fiscal crisis for the Western world as a whole, and (ii) that, if interest rates do remain low, governments should borrow more and more, safe in the knowledge that their extra borrowing will, eventually, deliver the kind of Keynesian multiplier needed to deliver a much-needed rebound in economic growth and, hence, in the labour market.

It's not at all obvious that interest rates will remain low and, even if they were to, it's even less obvious that a further Keynesian fiscal stimulus would do the trick. Low interest rates certainly help a government's fiscal position, particularly a government which has racked up huge debts in recent years (and that now applies to the vast majority of governments in the developed world). But households, banks, purchasers of mortgage-backed securities and investors in triple-A tranches of collateralised debt obligations a few years back also banked on low interest rates yet, as things turned out, their excessive borrowing bumped into the credit crunch which followed.

As Mr Krugman would surely accept, markets from time to time get it badly wrong (if they didn't, he wouldn't really need to be a Keynesian at all). It is the job of policymakers to think about risks to the current outlook and to make judgements on when to act upon those risks. To pretend that government debt can continuously rise with no consequences of note simply based on the market's current willingness to buy government bonds threatens a repeat at the sovereign level of the problems which led to the financial crisis in the first place.

Mr Krugman asks what sort of "model" Mr Trichet is using in order to reach his conclusion that it's time for a bit of belt-tightening and concludes that there is, in fact, no such model. That may well be true. But this is hardly a coruscating criticism. Plenty of models were used to provide a clean bill of health for the alphabet soup of 21st-century finances and those models, for the most part, suggested that ABS, MBS, CDOs and so on were all absolutely safe. Indeed, it was the attachment to models which partially explains the failure of governments, central banks, ratings agencies and banks to see the error of their ways. The models were too often constructed over relatively short time periods and failed to capture both the nuances of history and the systemic nature of the challenges which eventually unfolded.

Then, of course, there's the question of whether an additional fiscal stimulus at this stage would do any good. The obvious counterargument comes from Japan, where bigger and bigger budget deficits and rapidly rising government debt have been accompanied by year after year of deflationary stagnation.

At first sight, Japan's experience isn't helpful for someone of Mr Krugman's Keynesian disposition. As you might expect, however, Mr Krugman has an answer: "Japan's high debt years all lie in the era of deflation, and the natural presumption is that the country's macro problems caused high government debt, not the other way around." Certainly, this would be Mr Krugman's "natural presumption", but there are plenty of Japanese policymakers who might beg to differ.

Japan is a worrying example for Keynesians because the economy has had a tendency to deliver outcomes consistent with so-called "Ricardian equivalence". For every increase in government borrowing there has been an offsetting increase in corporate saving. As a result, there is no Keynesian multiplier effect and the economy continues to stagnate. Some would argue that Japan's rapidly rising government debt (200 per cent of GDP and counting) is encouraging company managers to save more (or, more precisely, repay more corporate debt) because they, rightly, recognise that Japan's fiscal position is completely unsustainable and fear higher future taxes. But, by repaying debt, Japanese companies are simply providing the funds to allow the government to borrow at remarkably low interest rates. This is a vicious non-Keynesian circle.

To be fair, Japan shows that it is possible to borrow hugely without bumping into a credit constraint. But that may be ultimately because the Japanese government's creditors are almost entirely Japanese and, hence, feel represented in the political process that deals with the relative claims of taxpayers, recipients of public services and creditors. For other nations, it's all too easy to ride roughshod over the interests of creditors because, nowadays, many of those creditors are foreign. Almost 50 per cent of US government debt is owned by foreigners, including the Chinese, the Saudis and the Russians.

To reveal what Mr Krugman really thinks about these creditors, it's worth going back to an article he penned in The New York Times on 14 March headed "Taking on China". He concluded:

"At this point, it's hard to see China changing its [currency] policies unless faced with the threat of [tariffs] – ... the surcharge would have to be ... say 25 per cent ... I don't propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world's economic problems at a time when those problems are already very severe. It's time to take a stand."

Alongside his unfortunate desire to go down the protectionist route, Mr Krugman is making the oft-repeated claim that America's own woes are a reflection of China's renminbi policy against the dollar. But let's turn the argument around. A renminbi revaluation is the equivalent of a dollar devaluation (obviously). China, however, has purchased vast quantities of US Treasuries. Should the dollar decline, the renminbi value of China's Treasury holdings will have fallen. In other words, a dollar decline is a mechanism to allow the US to default to its Chinese creditors.

And that, I think, sums up Mr Krugman's overall view about the need for stimulus. He cares about the current crop of American workers but he doesn't care about foreign creditors and nor does he seem to worry too much about the prospects for America's future workers. Should foreign creditors eventually walk away (put off by the recommendations of Mr Krugman and his ilk), the excess consumption of the current generation of US workers would crimp the spending power of future generations via a weaker dollar and higher interest rates. Austerity can be postponed, but it cannot easily be avoided altogether.

Stephen King is managing director of economics at HSBC stephen.king@hsbcib.com