Thursday, January 2, 2014

Austerity and the Euro in Two Graphs: A Reply to Paul Krugman

Paul Krugman started the New Year yesterday with a zingy little post in his New York Times blog titled “The State of the Euro in One Graph”. Here is the graph . . .

. . . and here is the text that accompanies it:
What you see here is that borrowing costs for the troubled euro countries have dropped a lot. But it’s not because austerity policies have brought their debt under control — debt ratios are still rising, in large part because of shrinking economies and deflation. Instead, there has been a dramatic flattening of the relationship between debt and interest rates.
Oops. I see two problems here.
  1. If “shrinking economies” are distorting fiscal policy indicators that are stated in relation to current GDP (and they are), shouldn’t his graph measure the debt ratio relative to potential GDP, not current GDP?
  2. Since when is the debt ratio the proper measure of austerity policy? Austerity, which we used to call fiscal consolidation, means reduction of the deficit, not the debt. The debt ratio is too strongly influenced not only by the state of the economy, but by past fiscal history, to be a good measure of year-to-year changes in the policy stance.  The chart is further muddled because debt dynamics are strongly influence by interest rates, the variable on the vertical axis.
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