Saturday, September 15, 2012

"Paul Krugman's Baltic Problem"

I've had problems with the so-called output gap for the last couple years. The usual presentation ends up drawing a line that tracks and extends the 2005-2007 trend line.
But what if the calculation of Potential GDP is wrong?

The methods for ascertaining Pmax can be divided into two large groups: 1)The GDP that would be attained if all factors of production in a country were utilized to their maximum capacity and 2) The GDP level corresponding to a growth rate sustainable into the medium and long-terms. The CBO does a good job explaining some of the methods to estimate potential GDP. Here is the usual presentation:

Gross Domestic Product
The question to ask is: "Was that mid-2000's GDP real or an artifact of the unprecedented growth of debt in both the the public and private spheres?"
What if "Okun's Law" is actually just "Okun's Strong Suggestion"?
If GDP growth was fueled by unsustainable debt, it was a chimera and we had better re-figure our assumptions on what maximum output of the economy actually is.
As Herb Stein used to say, “If something cannot go on forever, it will stop.”

Both The Economist and FT Alphaville looked at the growth question this year:
Limits to Growth: Is the U.S. Economy Running at Max Growth Rate?
A Strong Case That Economic Growth as We Know it Is Over

Growth may simply not be strong enough to employ the current labor force.
That means high levels of unemployment may be with us for a while.

Professor Krugman is an indefatigable champion of the output gap theory which may no longer be operative or even relevant..

With that pre-ramble here's the headline story from Foreign Policy:

Why is the Nobel Prize-winning economist mocking the countries that have escaped the eurocrisis? 
 Amid the carnage of the European financial crisis, the Baltic countries, by and large, are doing quite well. Estonia, Latvia, and Lithuania are booming. Last year, their growth rates reached 7.6 percent, 5.5 percent, and 5.9 percent, respectively. The turnaround, driven largely by manufacturing exports, has been one of the most remarkable and promising stories of the crisis. In 2008-2009, all three countries were badly hit by a nearly complete liquidity freeze, which sank their economies by as much as 24 percent. Even so, only Latvia required an IMF and EU bailout, and all three returned to growth after only two years of recession. Today, all three Baltic countries have ample access to international financial markets, and their credit ratings have risen steadily since the summer of 2009.

The Balts' rebound stands in stark contrast to the fate of eight mainly southern EU countries -- Hungary, Romania, Greece, Ireland, Portugal, Cyprus, Spain, and Slovenia -- which either already have or probably will require stabilization programs with external financial support.

So what happened?

The simple explanation is that the Baltic countries have pursued the opposite policy of the southern Europeans. In 2009, the Baltic governments each carried out strict austerity, with a fiscal adjustment of about 9.5 percent of GDP, mainly though expenditure cuts and substantial structural reforms. The southern Europeans, by contrast, delivered substantial fiscal stimulus in 2009. Previously fiscally conservative Cyprus and Slovenia ran up budget deficits of 6 percent of GDP in 2009, but neither benefited from greater growth. Instead, they have been trapped with large budget deficits and are now being overwhelmed by their public debt, admittedly also because of banking crises.

One would think, given the divergent outcomes, that a serious economist would advocate for countries to follow the successful example of northern Europe rather than the failed strategies of the south. Nobel laureate and New York Times columnist Paul Krugman doesn't seem to see it that way. Throughout the crisis, Krugman has attempted to explain away or even mock the Baltic countries' success even as they have continued to inconveniently disprove his arguments.

On Dec. 15, 2008, Krugman issued his first pronouncement on the Baltic crisis in a post titled, "Latvia is the New Argentina." He meant that Latvia would have to devalue its currency and perhaps default, as Argentina did in 2001. Neither happened. Latvia returned faster to fiscal health than anybody had anticipated. Krugman's claim that devaluation was necessary for Latvia's recovery (and presumably also Estonia and Lithuania's) turned out to be wrong.

Krugman's main line of argument has been that more fiscal stimulus is always needed as long as a significant output gap exists. But in Cyprus and Slovenia, very substantial fiscal stimulus generated minimal growth.  Neither country would be suffering from its current financial conundrum had it not followed such a policy. Spain would probably be safe as well....MORE
See also:
"President of Estonia Calls Paul Krugman Smug, Overbearing, and Patronizing"
Latvian Hookers Signal No Recovery for Economy
"Europe and the Law of Sticky Wages (technical)"
On top of morose, despondent, borderline suicidal, the Telegraph's Ambrose Evans-Pritchard is getting technical.
From the Telegraph...
It may well be that the only stimulus that works was the one tried in Latvia, back in 2009:

...On a more positive note, I researched this Sunday Telegraph story in depth:

Blondes march in Latvia 'to cheer-up nation'

Blondes march in Latvia 'to cheer-up nation'
The first-ever blonde parade featured women dressed in pink and white
Led by an orchestra, the first-ever blonde parade featured women dressed in
pink and white, some accompanied by lapdogs, in a charity fund-raising event that organisers hope will become an annual event....
...The parade was part of a "Blonde Weekend" which also featured a blonde golf tournament, a little lady fashion show, an evening ball, and a children's drawing competition.
"It's a great time to spend in the parade and contribute to a charity," said Ieva,
one blonde spectator. 
"Finally something different, something positive because I'm tired of hearing
about the crisis," said another, 70-year-old Ausma.
The event attracted many locals and puzzled tourists....
Apparently I am not the only analyst focused on this area:
RIA Novosti:

Latvian blonde parade to become annual event

Blonde girls parade in Riga
RIA Novosti Oksana Dzhadan

Der Spiegel:
Blonde Parade Lifts Spirits in Gloomy Latvia

Many of the women were followed closely by enthusiastic musicians....