Does Fiscal Austerity Reassure Markets?

This from Paul Krugman's blog. Please follow link to original.


Paul Krugman - New York Times Blog
New York Times Blog
June 13, 2010, 3:53 am
Does Fiscal Austerity Reassure Markets?

Here’s a thought I should have had earlier about the debate over whether now is a good time to start fiscal austerity.

For the most part, this debate has been between those like me and Brad DeLong, who assert that budget-cutting should be postponed until we’re no longer in a liquidity trap, and those who insist that we must cut immediately, even though it would inflict economic damage and do little to improve the long-run budget position, because immediate cuts are necessary to achieve credibility with the markets.

My response, and Brad’s, has been to say that right now there’s no hint in the data that the United States (or the UK) has a problem with the markets, and to question why the deficit hawks are so sure about what the market will want in the future, even though it doesn’t want it now.

But I suddenly realized this morning that there’s yet another question for the deficit hawks: what evidence do you have that fiscal austerity of the kind you’re demanding would reassure markets, even if they did lose confidence?

Consider, if you will, the comparative cases of Ireland and Spain.

Both countries appeared, on the surface, to be fiscally responsible until the crisis hit, with balanced budgets and relatively low debt. Both discovered that this was an illusion: revenues were buoyed by immense real estate bubbles, and when the bubbles burst they plunged into deficit — and found themselves potentially on the hook for large bank losses.

The countries responded differently, however. Ireland quickly embraced harsh austerity; Spain has had to be dragged into austerity, and still faces major political unrest.

So, how’s it going? This article is typical of what you read: it describes the Irish as doing what has to be done, while the Spaniards dither. And it has good things to say about how the Irish response is working:

Much bitterness but also stoicism; markets impressed by Irish resolve to bite the austerity bullet.

Well, I guess that’s right — if by “markets impressed” you mean a CDS spread of 226 basis points, compared with 206 points for Spain; not to mention a 10-year bond rate of 5.11 percent, compared with 4.46 percent for Spain.

So, I’m glad to hear that Ireland’s stoic acceptance of austerity is reassuring markets; it must be true, because that’s what everyone says. Because if I didn’t know that, I might look at the data and conclude that markets actually have less confidence in Ireland than they do in Spain, and that austerity in the face of a deeply depressed economy doesn’t actually reassure markets at all.

But hey, what are you going to believe: what everyone knows, or your own lying eyes?