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What Paul Krugman got wrong about Italy’s economy


In the last few days, while the US political debate centers on ways to deal with burgeoning debt, UK government debt has been downgraded and [investors are demanding much higher yields on Italian debt in the wake of the Italian election results (paywall). As concerns about national credit ratings push economies around the world toward austerity–government spending cuts and tax hikes–some commentators are still calling for economic stimulus at any cost. Joe Weisenthal wrote that David Cameron must spend more money in order to save the British economy. Paul Krugman wrote in “Austerity, Italian Style” that austerity policies simply don’t work. The downside of their prescription of more spending—and perhaps lower taxes—is that it would add to the United Kingdom’s and to Italy’s national debt. And national debt beyond a certain point can be very costly in terms of economic growth, as renowned economists Carmen ReinhartVincent Reinhart, and Kenneth Rogoff convincingly show in their National Bureau of Economic Research Working Paper “Debt Overhangs, Past and Present.”

Where do the United Kingdom and Italy stand in relation to the 90% debt to GDP ratio Reinhart, Reinhart and Rogoff identify as a threshold for trouble? (It is important to realize that their 90% threshold is in terms of gross government debt. That is, it does not net out holdings by other government agencies. ) In terms of gross government debt, Fergal O’Brien and Clementine Fletcher report on Bloomberg.com in their post “UK Stripped of AAA Rating by Moody’s Amid Outlook Weakness” that:

Britain’s debt as a percentage of gross domestic product will climb to 98 percent next year from 90 percent last year and 95.4 percent in 2013, the European Commission said in its winter forecast yesterday.

Things are even worse for Italy. Bloomberg.com reports that Italy currently has a debt to GDP ratio of about 120%.

In an environment in which stimulus is needed, but extra debt is a problem, there should be a laser-like focus on the ratio of stimulus any measure provides relative to the amount of debt it adds. In every one of my proposals for stimulating the economy, I have been careful to avoid proposals that would make a large addition to national debt. So I do not follow Joe Weisenthal and Paul Krugman in their recommendations.

First, instead of raising spending or cutting taxes, the Italian and UK governments can directly provide lines of credit to households, as I have proposed for troubled euro-zone countries and for the UK. Although there would be some loan losses, the ratio of stimulus in addition to the national debt would lead to a much better outcome. In particular, after full economic recovery in the short-run, there would be much less debt overhang to cause long-run problems after such a national lines of credit policy  than under Weisenthal’s or Krugman’s prescriptions.

But for the UK, it is an even more important mistake to think that monetary policy can’t cut short-term interest rates below zero. Weisenthal quotes a post on Barnejek’s blog, “Has Britain Finally Cornered Itself?” that illustrates the faulty thinking I’m talking about:

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

“Liquidity trap” is code for the inability of the Bank of England to lower interest rates below zero. The faulty thinking is to treat the “liquidity trap” or the “Zero Lower Bound,” as modern macroeconomists are more likely to call it, as if it were a law of nature. The Zero Lower Bound is not a law of nature! It is a consequence of treating money in bank accounts and paper currency as interchangeable. As I explain in a series of Quartz columns (123 and 4) and posts on my blog—that is a matter of economic policy and law that can easily be changed. As soon as paper pounds are treated as different creatures from electronic pounds in bank accounts, it is easy to keep paper pounds from interfering with the conduct of monetary policy. In times when the Bank of England needs to lower short-term interest rates below zero, the effective rate of return on paper pounds can be kept below zero by announcing a crawling peg “exchange rate” between paper pounds and electronic pounds that has the paper pounds gradually depreciating relative to electronic pounds.

In his advice for the UK, Weisenthal should either explain why having an exchange rate between paper pounds and pounds in bank accounts is worse than a massive explosion of debt or join me in tilting against a windmill less tilted against. And for those who read Krugman’s columns, it would take a bad memory indeed not to recall that he gives the corresponding advice of stimulus by additional government spending for the US, which faces its own debt problem. I hope Paul Krugman will join me too in attacking the Zero Lower Bound.

In 1896 William Jennings Bryan famously declared: “… you shall not crucify mankind on a cross of gold.”

In our time it is not gold that is crucifying the world economy (though some would return us to the problems that were caused by the gold standard), but the unthinking worldwide policy of treating paper currency as interchangeable with money in bank accounts. So for our era, let us say: You shall not crucify humankind on a paper cross.

Follow Miles on Twitter at@mileskimball. His blog is supplysideliberal.comWe welcome your comments at ideas@qz.com.

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