Monday, July 19, 2010

Paul Krugman, Iceland And The Council Of Foreign Relations: A Study In Conventional Incoherence

If there's one thing Serious People despise, it's being questioned. Never mind that the establishment has listed from one catastrophe to the next over the last decade; alternatively cheerleading the Iraq quagmire, financial deregulation, and -- now -- austerity. No matter the outcome, Serious People are always right; power absolves them of responsibility for the consequences of their actions.

So it shouldn't be too surprising that the "centrist" Council on Foreign Relations -- that venerable body that sees fit to employ know-nothing Amity Shlaes as an economic "specialist" -- has declared war on Paul Krugman. After all, as the leading Keynsian economist, Krugman has incisively and incessantly challenged the emerging conventional wisdom that budget deficits need to be immediately restrained and monetary officials should to be wary of incipient inflation. But even by their normally economically illiterate standards, their last attack is particularly baffling.

In their latest broadside, the CFR takes issue with Krugman's post on Iceland, which would have seemed relatively unobjectionable. Krugman merely pointed out that since Iceland controls its own currency, and can thus devalue it, they had fared much better during the financial crisis than other small, open economies. Indeed, the three countries Krugman compares Iceland to -- Ireland, Latvia and Estonia -- have been forced to maintain overvalued exchange rates, either because they're already a part of the Euro (Ireland), or have their currencies pegged to the Euro in hopes of joining (the recently admitted Estonia and Latvia), which has led them off an economic cliff. Unemployment has soared to Great Depression levels in the pair of Baltic states. Trimming their budget deficits and keeping their currency pegs in the face of the slump has starved their economies of any demand. Meanwhile, Ireland has suffered its own collapse and slide into deflation, thanks to the effective Gold Standard that is the Euro. That a quick devaluation is preferable to years of grinding deflation would seem obvious, yet it escapes the CFR.

Here, it's worth remembering too just how spectacular Iceland's bust was in 2008. Iceland's bankers quite literally bankrupted the country. After erecting their own mini-financial empires built on piles and piles of debt, Iceland's financiers left the country with a bill larger than its GDP when it all inevitably went bad. It's no exaggeration to say that Iceland suffered one of the worst financial collapses in history. And yet, just under two years later, Iceland is doing better than the aforementioned trio of Ireland, Latvia and Estonia, who have adhered to the economic orthodoxy of deflation and austerity with stunning zealousness. If ever there was proof that the large monetary shock of devaluation, which instantaneously makes exports more competitive, is an effective way to jump-start recovery out of severe recession, this would seem to be it.

But not so, says the CFR. See, if you just look at Iceland's performance compared to the others from a few months before the panic in see that Iceland only slightly outperforms the others, rather than clearly outpacing them. And if you go all the way back to 2000, Iceland has gained less in terms of GDP growth than the others! And if you go back to 1950....

Not only is this analysis misleading -- the question is how these countries have performed since the acute phase of the crisis hit -- but it entirely misses the point. By all rights, Iceland should be far, far behind the others; their banks owed more than their government could pay. As dire as the situations in Ireland, Latvia and Estonia were, they weren't quite that bad. But obstinate policy-makers have crucified their economies on a cross of Euros, which has condemned them to zero or negative growth and spiking unemployment. Meanwhile, Iceland has bounced back towards the beginnings of a recovery; something inconceivable two years ago. Of course, devaluation is not a panacea, but it's the best bad option in this context. This is rather elementary stuff.

It's as if the CFR is bellowing at Krugman for presuming to question the great Oz, not realizing that the curtain has been drawn on their intellectual bankruptcy. Eventually, the truth always wins out.