German Fiscal Policy, or "Other Things Paul Krugman is Wrong About"

by Pejman Yousefzadeh on July 18, 2010

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Now that it has been established (one hopes!) that Paul Krugman is not an expert on health care policy, perhaps it would be timely to point out that Paul Krugman is also not an expert on fiscal policy.

Krugman has been on something of a tear against Germany, for taking a tough line against deficits. He thinks that the German decision to be anti-Keynesian is downright suicidal, economically. But as Tyler Cowen points out, far from being suicidal, the Germans are showing that they know what they are doing:

In recent times, Germany has shown signs of regaining a pre-eminent economic position. Policy makers have returned to long-run planning, and during the last decade have liberalized their labor markets, introduced greater wage flexibility and recently passed a constitutional amendment for a nearly balanced budget by 2016, meaning that the structural deficit should not exceed 0.35 percent of gross domestic product.

Amid the sluggish economies of much of Europe, Germany has booming exports and is nearing full capacity utilization. And many of its workers are postponing vacations to produce, and earn, more. The unemployment rate in Germany is 7.5 percent — below that of the United States — and falling.

Far from embracing this social democratic model, American Keynesians have criticized it for relying too heavily on exports and not enough on spending and debt. Yet it is not just the decline in the euro’s value that supports the German resurgence.

Most of the other euro-zone economies are not having comparable success because they did not make the appropriate investments and reforms. Moreover, the euro is still stronger than its average value since 2001, which suggests that the recent German success is not attributable only to a falling currency.

In any case, the Germans are exporting much quality machinery and engineering (not just glitzy autos), which can help other nations recover. It is an odd state of affairs when the relatively productive nations are asked to change successful policies because of an economic downturn.

Krugman, content to keep digging when he is in a hole, counters by essentially calling Cowen a dumb-dumb. But one wonders why he thinks that his response is effective in any way.

Concerning Krugman’s first and second points, while no one was concerned about the West German unemployment rate post-unification, there certainly were concerns about the East German unemployment rate, which means that there were, at the very least, regional deflationary concerns specific to East Germany; note Krugman’s own comment that high unemployment brings about deflation as a “proximate risk.” As noted here, the unemployment rate in East Germany in 1992 was a whopping 15%. It went up to 16% in 1993, and remained steady in 1994. It was between 7-8% in West Germany during those periods. Unemployment in the former East Germany remains higher than it does in the West. Thus, contra Krugman, there were very real unemployment concerns post-unification, as East Germany struggled on the labor front, which helped raise legitimate deflationary concerns. The German government’s spending, as a consequence, did take place in depressed demand conditions, with high unemployment in East Germany haunting German policymakers.

But what about Krugman’s third point, which is that the Bundesbank’s decision to raise rates showed that there was no zero bound? Krugman makes it sound as though inflationary concerns stemmed from the fact that the German economy was doing well and did not have unemployment concerns, but as the above paragraph shows, the German economy was suffering significant unemployment in the East, which naturally raised deflationary concerns. To the extent that deflation was avoided, it was not because the employment situation was ideal. Rather, it was because of policies concerning the post-unification exchange rate, which Wikipedia actually covers (and Krugman does not):

When a customs union was created between the former East Germany (German Democratic Republic) and West Germany (the “old” Federal Republic of Germany), there was a dispute over the rate of exchange for conversion of East German money to Deutschmarks. The Chancellor (Helmut Kohl) decided to ignore the advice of the Bundesbank, and chose an exchange rate of 1:1. The Bundesbank feared that this would be excessively inflationary as well as very significantly impairing the economic prospects of the area of the former East Germany. This dispute was particularly public because of the Bundesbank policy of communicating openly on such matters. Although public opinion normally supported the Bundesbank in matters of combating inflation, in this case Helmut Kohl prevailed, and the President of the Bundesbank, Pöhl, resigned. The Bundesbank had to use monetary measures to offset the inflationary effect.

So deflation was avoided, and rates had to be raised. But they weren’t raised because the German economy had reached anything resembling full employment, with low demand. No one could argue that it had, with East German unemployment rates hovering in the 15-16% range. Yet, reading Krugman, one would naturally think that East German unemployment simply was not a factor.

All of this shows, of course, that Cowen has the better of the argument, both in terms of the debate over the German economy in the immediate post-unification stage, and in the debate over what Germany–and the United States and other developed countries–ought to do with regard to future fiscal and economic policies. I understand that Krugman is loath to admit that Keynesian stimulus policies don’t work, and anytime anyone brings forth an example of them not working, Krugman tries to argue that said example is not apt. It should surprise no one that his arguments on this issue have a tendency to be highly misleading.

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