Krugman and Germany: Both right and wrong on Greece

Paul Krugman prescribes a Keynesian remedy for the Greek disease. Europe and the IMF don't concur. Which side is right? As it often happens in economics, both are.

Greek-Eurozone protest.
Our family version of a sign giving vent to one side of the Greek-Eurozone argument. Why in English? Who knows? (Via an apparently left-wing Greek Facebook page)

WASHINGTON, July 20, 2015 — Nobel Memorial Prize winning economist and New York Times columnist Paul Krugman has condemned Germany for offering, and the Greek government for accepting, a bailout plan that is based on Greek austerity and possible future debt relief. Germany responds that Krugman doesn’t understand the European currency union and the macroeconomic environment of the European Union. Both are right, and both are wrong.

Germany led the European Union to develop a bailout plan for Greece. The deal would allow Greece to borrow up to $96 billion. In return Greece would agree to austerity measures including deep pension cuts, higher taxes, and the sale of some government assets. There is no forgiveness of debt at this point.

Krugman, who received his Nobel Prize for his work on foreign trade, is a devout Keynesian economist. Keynesians believe that the federal government should set the levels of spending and taxes each year to maximize economic growth, reach full employment, and minimize inflation. It does not matter if spending and taxes are equal or whether the budget is balanced. What matters is this year’s economic conditions.

Keynesians discount the importance of annual deficits. That money is owed primarily to other Americans, and the Federal Reserve can simply create more money to purchase the government bonds used to finance the annual deficit.

This economic philosophy became mainstream in 1962 when President Kennedy followed Keynesian logic to justify his large tax cut. Since 1962, the federal budget has been in deficit in 50 of 53 years. This has produced an approximately $18 trillion public debt, with net interest payments in fiscal 2013 of $223 billion.

In the 1980’s, mainstream economists began in large numbers to abandon this philosophy and focus on the use of monetary policy to achieve economic goals. By the late 1990’s, the annual budget deficit was eliminated; the economy grew with little inflation and low unemployment. Small deficits reappeared during the early 2000’s.

In 2009, the current administration followed the Keynesian recipe to tackle the recession. The results have been poor. Annual deficits are two to three times higher than previous deficits, and a stagnant economy hasn’t seen annual growth exceed 2.5 percent. Unemployment has fallen, but mostly because so many adults have simply stopped looking for work. The are able to do this because the administration has made it easy to get extended unemployment benefits, food stamps, welfare and nearly free health care.

Krugman now believes the same policies should be followed in Greece.

He is right when he says that austerity measures will put a drag on economic growth. Economic growth is really what is needed to get Greece out of its current problems. But since Greece has had policies for years which have encouraged people to stop working and to collect payments from the government, their annual deficits have mounted into a crippling public debt. Add to that a high level of corruption and a high level of tax evasion and avoidance, and the debt problem becomes worse.

Germany, speaking for the entire European Union, has agreed to lend money, but only after Greece institutes austerity measures. They are right to say that before you can get out of a deep hole, you have to stop digging.

But Krugman believes they are wrong to insist on action that will slow down growth. Krugman is right — government action should be geared toward growth, not austerity — but to advocate more deficit spending to achieve this growth. That will only dig a deeper hole.

Given the pros and cons of each position, Germany and the European Union offer the best solution. Krugman’s Keynesian view would help Greece more today, but would likely lead to a deeper crisis in the near future. Germany’s approach will lead to more hardship today but will likely lead to a permanent, long-term, future solution.

Unlike most American politicians, German leaders choose not to not kick the can down the road, but rather to face the issues head-on today. The U.S. should learn from Germany.

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