Wednesday, June 13, 2012

Krugman vs. Estonia 2.0

I wrote an opinion letter for the New York Times, it was not published.  But it did get published on our institute's euroblog in an Estonian newspaper. I thought I would post the English version it here.  It said basically the same thing as what Jeff said in his comment on my last blog post.  Just for the record, I came to the same conclusion as Jeff before reading his comment. 

Krugman vs. Estonia 2.0
Paul Krugman’s recent blog about Estonia’s supposedly not so impressive recovery was followed by a surprising, and to be honest inappropriate, Twitter response by Estonian president Toomas Hendrik Ilves.  Unfortunately President Ilves decided to personally attack Paul Krugman rather than offer a rebuttal to his argument.  Paul Krugman was right to take up the issue whether austerity has been a good thing for Estonia, but he did it in the wrong manner.
As the battle between Keynesian economics and Austrian economics continues (austerity or stimulus), a similar pattern continues to emerge.  Austrian economics makes a lot of sense in theory but there are few real life examples to prove those theories.  Keynesian economics continues to be the dominant school of thought in most countries.  Estonia has given the Austrian school a real life example that proves their theories correct.  It is only logical that Krugman would attempt to debunk the Estonian austerity miracle.  Krugman in his blog entry unfortunately attempted to manipulate data to prove his point.  Estonia’s austerity policy and the results of that policy merited much more attention and detail than Kugman gave.  By comparing Estonia’s recovery to the tip of the boom cycle (2007), Krugman conveniently ignored the fact that the GDP growth, that lead up to 2007 was not sustainable.  It was built on a large property bubble and high levels of consumer debt, not production.  Also, Estonia’s recovery is real and significant.  The unemployment level is falling, wages are rising, and the economy is growing.  Best of all Estonia is virtually debt free and the economy will not be bogged down by future debt payments.
This does not mean that Estonia should be the poster child for austerity.  What Estonia did would be difficult for any other country to achieve (except for the other Baltic states).  Estonia did not own any state banks, so it did not need to provide an expensive bank bailout.  Estonia’s domestic market is not overly important to its macroeconomic outlook.  So while austerity measures did cause domestic consumption to fall drastically, the Estonian economy was still boyed up by European structural funds, strong export markets, and a large flow of capital from neighboring countries.  Estonia’s neighbors Finland, Sweden, and Russia weathered the storm rather well, this in turn made Estonia’s austerity miracle possible.   Estonia’s export market was strong, tourism and transit money continued to flow in, and many unemployed Estonians were able to find work abroad (mostly in Finland) and send their remittances back home to Estonia.  The US’s economy, for example, is more based on consumer spending.  If consumer spending were to tank due to austerity, there would not be other external funds to off-set the drop.  This could result in a nasty downward spiral with no way out. 
The austerity that the Austrian economists recommend is a very risky proposal that needs to be verified.  The lack of real examples to prove their theories correct is worrisome and this is why the example of Estonia needs further study.  The economic policies Estonia has pursued could be a case study that finally confirms what the Austrian economists have been preaching.  This is why it was extremely unfortunate to see Krugman devote only 65 words and misleading statistics to debunking the Estonian austerity miracle.  Even more disappointing was President Ilves, who choose to personally attack Paul Krugman rather than spend time explaining the values and achievements Estonia has accomplished.  Both Keynesian and Austrian economists should take time to study the Estonian example in detail to see if it can play a role in deciding which macro-economic theory can best help the world get out of this financial crisis.  While the first spat between Krugman and Estonia was entertaining, a second round is needed. 

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