Paul Krugman vs. President of Estonia
First economist Paul Krugman showed some doubts about Estonian economy. Then Toomas Hendrik Ilves, President of Estonia, had some pretty harsh words about Krugman on Twitter. Who is right here? We have to look at the background here.
1. Background of the story
Austerity or not? This is probably the hottest topic globally among economists. Followers of Keynes are talking about risks of austerity, how this could cause the downward spiral for economy (austerity cools economy and decreases government revenues). The Austrians are promoting austerity to get government deficit under control. The disucssion has become quite heated, Krugman has had battles with congressman Ron Paul and british economist Niall Ferguson. And the increased tone of the debate is understandable because the decisions on that matter will influence global economy greatly.
And this is the background why Krugman posted about Estonia, he has been fighting against austerity and recently on BBC (here is the video) Estonia was showed as a positive example of austerity. Krugman was also in the studio and took issue with it, hence the half-negative post about Estonia.
2. Austerity or not?
It's a highly interesting topic and it requires more detailed analysis than we have room here, I will try to write about that soon. But shortly - Krugman is against austerity, because the mentioned downward spiral risks it can bring. He wants higher inflation, more money printing (QE8!) and austerity can only be used in the future when the economy is on the stable footing. Probably not during this decade then.
If the world economy would be run the "Krugman-way", then we would probably have two or three really good years, but the risk of total collapse of the system would increase greatly. Inflation could get out of control and if US government debt reaches 150% of GDP, then it could be the new Greece. And that is a risk that at least I wouldn't take. But sadly - since the politicians could be out of their offices by the time those risks arrive - there is more and more support for the "Krugman-way".
Lot of people who are against austerity are quoting Keynes. But while Keynes said that governments must increase spending during downturns, he also said that they must save money during good times. And this is something that People Against Austerity (PAA) tend not to notice. If US would have had government surplus during good times, I would support some more austerity. But they did not. Even during one of the hottest booms during last couple of decades US had a budget deficit during 2004-2007. And when the crisis came, the deficit increased to new records.
Take a look at the chart below, where the government deficit of Estonia and US are compared. Estonia managed to save up during good times, US did not. When the government debt is reaching 100% of GDP in US and budget deficit is around 9% (that is over a trillion dollars), talking about additional stimulus looks suicidal to me.
3. Krugman's criticism about Estonia
Looking at the background, it is quite obvious that Krugman does not like Estonia's example that much. If you are talking about risks of austerity, it can be quite annoying if people keep bringing up the example of some small country near the end of the world where austerity has worked.
Therefore it is understandable that Krugman showed a chart that showed Estonia in a bad light - GDP levels being down from the market top in 2007. But that is only half of the story - the reason why Estonia's fall from top was that steep is because the boom before that was so big. The 2003-2007 boom was similar to the western world - real estate and rising debt levels, but the tempo was much faster for Estonia. And therefore the 2008-2009 fall had to be steeper as well. Here is the the long term chart for Estonia's real GDP. As you can see the GDP level is much higher than in 2000, more than in US for example.
I think that Estonia's austerity in 2008-2010 period was tough, but it had to be done. Estonia has now adjusted the economy to "new normal", more than Western Europe or US. That helps us to move forward and focus more on growth issues. I agree that stimulus in other countries has helped Estonia's exports, but the more important issue has been the increased competitiveness.
Sure, Estonia is a very open economy and global downturn would hurt Estonia as well. But definitely not so much as in 2009, the economy is now on a more stable footing. Can the same be said about Spain or US?
Finally, one interesting thought - Eurozone is dealing with austerity, that surely hurts the economy. But government deficit in Eurozone in 2012 is probably going to be around 4%, while in US the same number is near 9%. Wouldn't US have as big of a crisis than Europe, if they would balance their budgets to the 4% level? Probably.