Contrary to Keynesians, Cuts Help Default‐​Prone

June 10, 2011 • Commentary
This article appeared in Investor’s Business Daily on June 10, 2011.

A wise person once explained that good judgment can only be attained through experience, and experience often comes from bad judgment. There was a profusion of bad judgment behind the latest European debt crises. What did we learn?

One thing we should have learned is that a credible plan for deficit reduction requires action, not words. Overly indebted countries that have actually done something to restrain government spending faced much lower long‐​term interest rates than those that dissembled and delayed.

On the other hand, long‐​term interest rates can double quite suddenly if such countries reverse course and rack up so much debt that bondholders fear partial or total default. As it happens, Ireland illustrated both experiences last year, switching from good to bad judgment within a few months.

Ireland was the first of the debt‐​plagued European countries to cut government consumption significantly in 2009, mainly by reducing government paychecks from 12.3% of GDP in 2009 to 11.8% in 2010.

While such gestures toward fiscal frugality lasted, the country was rewarded with a tolerable risk premium on government bonds. The yield on 10‐​year Irish government bonds was still 5.3% as recently as last August, compared with 10.7% in Greece. This May, the interest on Irish bonds reached 17.6%. What went wrong?

Back in June 9, 2010, I wrote that “unlike Greece, the Irish economy is showing encouraging signs of recovery.” Ireland’s real GDP had increased by 1.7% in the first quarter, with an 11.7% quarterly rise in industrial production. Manufacturing output increased 29% from November 2009 to July 2010, thanks to growing exports.

Within fewer than four months, however, a terrifying series of fiscal blunders began to unfold. The Wall Street Journal reported last Sept. 24 that, “in recent weeks, some investors have begun to fear a Greece‐​style bailout for Ireland, though most observers say it is unlikely for now.”

Such fears intensified on “Black Thursday,” Sept. 30, when the BBC reported, “The cost of bailing out the Republic of Ireland’s stricken banks … will see the government run a budget deficit equivalent to 32% of GDP this year.” There were mass protests against the bank bailouts in the streets of Dublin that day, and the risk spread between interest rates on Irish and German bonds jumped above 4 percentage points for the first time.

Foolish Banks
The Irish government had suddenly opted to lift the expected budget deficit from an expected 12% of GDP to 32%. The national debt quadrupled from 25% of GDP in 2007 to 100%-125% in 2011. Why? To bail out foolhardy Irish banks that had bankrolled the world’s looniest housing bubble. That really meant bailing out foreign banks that loaned nearly $700 billion to the troubled Irish banks.

The government continued to insist that it would not resort to a Greek‐​style bailout, however. Without the EU and IMF serving as enabling lenders, the Irish politicians’ impulse to coddle bad bankers appeared constrained by a lack of funds. That flicker of hope ended in November.

On Nov. 16, the New York Times reported that “European finance ministers (had) met in Brussels to pressure a reluctant Ireland to accept an $80 billion financial rescue plan. … A significant part of the pressure has also come quietly from the European Central Bank, which has been buying sovereign bonds and supporting the banks with billions in liquidity.”

If such a “bailout” had been a solution rather than a grave danger, Irish interest rates would have gone down. On the contrary, the yield on Irish bonds jumped above 8% the next day and to 9.25% by Nov. 20 — before the deal was even sealed. On Nov. 22, the Irish government caved in to demands of European officials and the U.S. Treasury Secretary, and Irish interest rates kept climbing ever since.

“Eating the Irish” was the apt title of a marvelous New York Times column by Paul Krugman on Nov. 25. “The (housing) frenzy was financed with huge borrowing on the part of Irish banks, largely from banks in other European nations,” he explained. “Then the bubble burst, and those (European) banks faced huge losses.

“You might have expected those who lent money to the banks to share in the losses. … But, no, the Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations.”

By contrast,” Krugman added, “Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts.”

It is not that Iceland suffered less economic pain than Ireland. Iceland experienced lower unemployment but much higher inflation. The main point is that future taxpayers in Ireland will be much worse off than those in Iceland because of the public debt squandered on protecting Ireland’s bank creditors from an Iceland‐​style receivership.

Any country saddled with more debt than it can handle cannot afford to borrow tens of billions to bail out reckless banks that happen to have the word “Ireland” or “Irish” in their names. Irish consumers and companies are far more likely to get credit from dozens of foreign banks in Dublin than from insolvent Irish banks.

Krugman was entirely right about Irish bank bailouts. But he ruined it by adding something strange. He said, “Ordinary Irish citizens are now bearing … a burden much larger than the debt — because those (government) spending cuts have caused a severe recession.”

What spending cuts? As Eurostat reports, Irish government spending rose from 42.8% of GDP in 2008 to 48.2% in 2009 and to an astonishing 67% of GDP in 2010. Krugman’s claim that savage “spending cuts caused a severe recession” is factually fatuous.

The recession was caused by the collapse of an incredibly inflated housing bubble. A 2010 OECD study found that Irish home prices rose 310% between the third quarters of 1992 and 2006, before falling more than 40%. Recession began in the first quarter of 2008, when real GDP fell by 1.3% and construction by 16%.

Krugman’s column of March 24, 2011, “The Austerity Declusion,” used Ireland as the prime example of why “slashing spending in the face of high unemployment is a mistake. … Just ask the Irish, whose government … tried to reassure markets by imposing savage austerity measures on ordinary citizens. The same people urging spending cuts on America cheered.

“ ‘Ireland offers an admirable lesson in fiscal responsibility,’ declared Alan Reynolds of the Cato Institute, who said that the spending cuts had removed fears over Irish solvency and predicted (sic) rapid economic recovery. That was in June 2009. Since then, the interest rate on Irish debt has doubled.”

Actually, I wrote in June 2010, not 2009. The timing is important because the doubling of Irish interest rates in such a short period was as surprising as the plan to raise the budget deficit to 32% of GDP. That caught me by surprise just as it caught the bond market by surprise.

Krugman misquoted me on two other occasions (Dec. 10 and April 26) because I failed to predict Ireland’s unaffordable bank bailout six months before it happened. In his retelling, my factual description of “encouraging signs of recovery” in Irish industry last June has been reinterpreted as meaning “rapid recovery” or “resounding success.”

All this attention is flattering. But Krugman’s description of Ireland’s recent economic events does not hang together. He describes the (totally unexplained) doubling of interest rates in late 2010 as causing reductions in government salaries in 2009, and allegedly draconian “spending cuts” in 2010 as causing a recession in 2008.

Krugman would have you believe that the doubling of Irish bond yields in late 2010 proves that even the slightest spending restraint in a country threatened with national bankruptcy is a savage mistake. He suggests that spending more borrowed money would have provided a Keynesian “stimulus” in Ireland, and presumably Greece, although Ireland and Greece can only borrow at grueling interest rates.

Whenever a nation gets to the point where it must pay a punishing risk premium just to roll over old debts, it is irrational to suggest that “slashing spending is a mistake.” What else is a country in that fix supposed to do? Raise taxes? Ireland recently raised the highest income‐​tax rate to 49%, so skilled Irish workers can give themselves a raise by moving to France, which cut the top tax to 40% in 2006.

Pumping Iceland
Three studies in 2010 alone examined previous efforts to get government budgets under control — one by Alberto Alesina and Silvia Adragna at Harvard, and two others by economists from Goldman Sachs and the American Enterprise Institute. They all found that major spending cuts were entirely beneficial, even in the short run.

Reducing government spending and debt improves expectations for long‐​term growth because the lighter burden of interest payments reduces the threat of increases in distortionary taxes. Higher tax rates, by contrast, invariably aggravated fiscal problems by weakening the economy — a conclusion confirmed by the IMF and by former Obama adviser Christina Romer.

Krugman’s contrary advice to avoid “slashing spending” is based on a misreading of Ireland’s experience in late 2010. It was certainly not because of “savage austerity” that “the interest on Irish debt doubled.” Does government spending of 67% of GDP and a budget deficit of 32% of GDP sound like savage austerity?

Krugman praises Iceland, while castigating Ireland. Yet Iceland reduced government spending by 8.8% of GDP from 2008 to 2010 while Ireland raised government spending by 24.2% of GDP. Once again, his evidence contradicts his policy advice.

Any default‐​prone country paying superhigh interest rates will be gravely harmed, not helped, by Keynesian “fiscal stimulus.” Such a country will be greatly helped, not harmed, by making the deepest possible cuts in government payrolls, transfer payments and, of course, subsidies to businesses and banks.

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