UK: Deloitte Monday Briefing: Krugman vs. Estonia

Last Updated: 15 October 2012
Article by Ian Stewart

Most Read Contributor in UK, August 2017

* Last month Estonia's Finance Minister, Jürgen Ligi, spoke at an London School of Economics seminar on the subject of 'Why Paul Krugman is wrong: lessons of Estonia for other European countries".

* The title may sound baffling but the subject is at the heart of the debate about how to revive growth in the Western world.

* Paul Krugman is a Nobel laureate in economics and writes a column for the New York Times. Professor Krugman is arguably America's most influential Keynesian economist, someone who sees spending cuts and tax rises as exactly the wrong prescription for Europe's or America's economic woes.

* In June Professor Krugman took issue with those who saw deep cuts in public spending in Estonia and the subsequent rebound in growth as a model of successful austerity. He tweeted, "So, a terrible — Depression-level — slump, followed by a significant but still incomplete recovery. Better than no recovery at all, obviously — but this is what passes for economic triumph?".

* This prompted a furious reaction from Estonia's President, who, in a series of tweets called Professor Krugman, "smug, overbearing and patronising".

* Professor Krugman's view is that, while the Estonian growth has rebounded in the last 3 years, the economy is still almost 10% smaller than at its peak in 2007. On this measure deep cuts in public spending and tax rises have failed. To Professor Krugman Estonia provides a cautionary tale for the US of the damaging effects of aggressive fiscal retrenchment.

* Estonia's Finance Minister, Jürgen Ligi, has a different view. In his remarks at LSE Mr Ligi argued that Estonia's deep recession was an inevitable response to the bursting of a credit and asset price bubble, not the result of government austerity. Pre-crisis GDP had been artificially inflated by the boom and it was unrealistic to expect the economy to return to such levels swiftly. Growth depended on make the private sector more flexible and competitive, not on government spending. For Mr Ligi, Estonia's experience shows why the euro area needs more austerity and reform, not less.

* The arguments are complex and the issues contested. But here are some of the facts behind the debate.

* The Estonian economy suffered a huge, near 20% contraction in 2008-09 and it will take years of growth to regain this peak. Estonia has fared better in recent years than other smaller economies which suffered boom bust cycles such as Greece or Portugal. The IMF forecasts that Estonia will grow at 3.5% over the next 5 years, just half its pre crisis average, but a stronger growth rate and rate of recovery than in Greece, Portugal, Spain, Ireland or Italy.

* A fundamental difference of opinion about government borrowing and government activity lies at the heart of the disagreement between Professor Krugman and the Estonian government.

* To Professor Krugman ultra-low government bond yields are a symptom of economic weakness and demonstrate the need for the state to boost demand. In such circumstances governments – or at least those, such as the US and UK, which control their own currency - should take advantage of low interest rates to borrow, spend and boost demand. Stronger activity, in turn, will create a virtuous circle of growth and a narrowing budget deficit.

* The Estonian view is that no country, especially small ones, should take the goodwill of the bond market for granted. They worry that high levels of borrowing and doubts about the public finances could cause bond yields to rise sharply, as they have in the south of Europe. Growth will necessarily be more subdued without the cheap and easy credit of the boom years. To the extent that the economy can grow, that growth must come from the private sector, not the state.

* This is an old debate. In 1932 two of the twentieth century's greatest economic thinkers, John Maynard Keynes and Friedrich Hayek, debated how government should respond to the Great Depression in this extraordinary exchange of letters in the Times:

* The debate rumbles on 80 years later. As New York Union Professor Mario Rizzo puts it, "The great debate is still Keynes versus Hayek. All else is footnote".

* Today the climate of opinion among international policy makers on public spending seems to be shifting.

* Last week the International Monetary Fund (IMF), a staunch advocate of "sound" finances, suggested that countries with "room to manoeuvre" should smooth the adjustment in public finances, "over 2013 and beyond". We take this to mean that the IMF believes that countries such as Germany, the US and UK which have low government yields, can slow the pace of cuts in public spending to support growth.

* For an organisation nicknamed "It's Mostly Fiscal" for its support for austerity this marks a significant change in thinking. The goal of eliminating deficits remains the same, but the IMF is giving a green light to more creditworthy governments to ease the pace of austerity.


The FTSE ended the week down -1.3% following poor macroeconomic data globally.

Here are some recent news stories that caught our eye as reflecting key economic themes:


* The IMF cut its forecasts for global GDP growth in 2012 from 2.0% to 1.5% for advanced economies and from 6.0% to 5.6% for emerging economies – slowdown

* The proposed merger between aerospace and defence firms BAE Systems and EADS was cancelled, following political deadlock over terms – M&A

* The UK's total trade deficit rose to £4.17bn in August, the second highest level on record, due largely to falling exports and rising oil imports – current account

* UK construction output fell 12% in Q3 2012 compared to the same period last year – slowdown

* Ratings agency S&P downgraded Spain's credit rating to BBB-, one level above junk status, citing "mounting risk to Spain's public finances, due to rising economic and political pressures" – Spain

* The eurozone's permanent bailout fund, the European Stability Mechanism (ESM), was formally inaugurated by eurozone finance ministers, with €500bn of funds – euro crisis response

* Italian prime minister Mario Monti announced a percentage point reduction in the country's two lowest income tax rates, claiming the country "can allow ourselves some moderate relief" – Italy

* A Politbarometer survey for broadcaster ZDF showed that 46% of surveyed Germans think Greece should stay in the eurozone, with 45% believing the should exit – the first time in more than a year that more have supported Greek eurozone membership than oppose it – euro crisis opinions

* For the first time in 11 years, the worldwide market for personal computers (PCs) is likely to shrink in 2012, according to forecasts from research firm IHS – technological revolution

* Internet firm Google Inc launched its own credit card, offering customers of their AdWords online advertising business between $200 and $100,000 in credit – corporate cash

* Norway's sovereign-wealth fund bought a 50% stake in the UK's Meadowhall Shopping Centre for £348m – M&A

* Coca-Cola Hellenic, Greece's biggest company by market value, announced it is to move its operations to Switzerland and list its shares in London, citing the "clear business sense" of moving – Greece

* European Central Bank (ECB) board member Joerg Asmussen said that it would be "illegal and illogical" to offer Greece additional time to pay its debts – euro crisis response

* The Italian Catholic Church is to be stripped of a historic tax exemption from 2013, potentially raising the Italian Government €25.5m a year in property tax revenues according to La Repubblica newspaper- Italy

* The University of Cambridge is to issue its first ever bond, to raise £350m through a 40-year security, after being given a top credit rating from Moody's – university finances

* An unidentified computer programme briefly made up 4% of all traffic on the US stock market, placing orders in 25-millisecond bursts before cancelling them, according to market data firm Nanex – algo trading

* Barclays Bank agreed to buy ING Direct UK from Dutch banking group ING, assuming control of £10.9bn deposits and a £5.6bn mortgage book – M&A

* The combined pension deficits of Britain's FTSE 350 companies fell by a third in September, thanks partly to proposed changes in how retail price inflation is to be calculated, according to consultancy firm Mercer – pension deficits

* Spanish mobile phone operator Telefonica is to launch a new division called Telefonica Digital to offer "analytical insights" about its customers – big data

* In its October World Economic Outlook, the IMF claimed that "Uncertainty [in the global economy] appears more diffuse, more Knightian in nature" – more uncertainty

* An internal investigation at investment firm Goldman Sachs found little substance to allegations made by Greg Smith, a former employee who claimed the bank has a "toxic environment" where bankers refer to clients as "muppets". A search of employees' emails for the word "muppet" found 4,000 uses of the term, 99% of them referring to last year's movie of the same name – muppet hunt

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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