Is Iceland Krugman’s Inadvertent Case for the Monetary Policy Offset of Fiscal Policy?

A Mark Sadowski post

On May 28, Paul Krugman exclaimed:

 “Back in 2013, when Olivier Blanchard presented a paper on Latvia at the Brookings Panel, many of the participants were bemused: why was the august panel devoting so much time to a country with the population of Brooklyn? But Latvia was, for a time, the great poster child for austerity….And now, as Frances Coppola notes, the era of rapid bounce back has stalled out.”

Krugman proceeds to compare the Real GDP performance of Latvia with that of Iceland. If one clicks on through to Coppola’s post, they learn that Latvia “embarked on a brutal front-loaded fiscal consolidation in 2009, sacking public sector workers, slashing public sector salaries, cutting benefits and raising taxes.”

Then on June 9, Krugman states:

 “I was, I think, one of the first commentators to notice that a funny thing was happening in Iceland: the nation that was supposed to be Ground Zero for financial disaster was actually having a milder crisis than many others, thanks to heterodox policies — debt repudiation, capital controls, and massive devaluation. Now, as Matthew Yglesias points out, Iceland is getting ready to lift the controls, and its experience still looks remarkably good considering the circumstances.

And as Yglesias says, the interesting contrast is with Ireland, now being hailed as a success story for austerity because things eventually stopped getting worse and have lately been getting a bit better. Talk about lowering the bar.”

If one reads the post by Yglesias, they find out that one of the things that Iceland did to achieve this was to “[r]eject [fiscal] austerity.”

Anyone who came away from reading Krugman’s posts, and the posts to which he links, might be forgiven for concluding that Krugman thinks that Iceland, unlike Latvia and Ireland, did not do any fiscal austerity at all.

But Scott knows something is fishy in the state of Iceland, and looks into Krugman’s implied claim.

 “Sorry, but I don’t see it. The crisis caused the debt to balloon, presumably due to the big cost of paying off depositors of failed banks, and the effects of the recession itself. But then Iceland started reducing debt as a share of GDP, from 101% to 86.4% in just three years. That’s much better than the US and UK, which supposedly had austerity. The budget deficit in Iceland was 7.8% of GDP in 2009, but only 0.9% of GDP in 2013–better than the US and far better than the UK. So if the US and UK practiced austerity, what’s so different about Iceland?”

As often is the case, in my opinion Scott is somewhat understating things.

Scott is looking at the “net operating balance” which excludes the “net acquisition of nonfinancial assets”. Including this item results in “net lending”, which is what Europeans call “the deficit”. The net lending of Iceland’s general government fell from 9.7% of GDP in calendar year 2009 to 1.7% of GDP in calendar year 2013, a change of 8.0% of GDP.

Moreover, Iceland’s general government budget ran a surplus equal to 1.8% of GDP in 2014, or a change in fiscal stance since 2009 equal to 11.5% of GDP. This can be found on Table A1 of the April 2015 IMF fiscal Monitor.

And, according to IMF estimates, Iceland’s output gap was actually somewhat larger in 2014 than in 2009. When an economy becomes more depressed it usually results in falling revenues and rising expenditures as a percent of GDP. Not taking this into account might tend to understate the amount of fiscal austerity a country has engaged in (e.g. Greece). Table A3 shows that Iceland’s general government cyclically adjusted balance rose from a deficit of 10.0% of potential GDP in 2009 to a surplus of 2.7% of potential GDP in 2014, or a change of 12.7% of potential GDP.

But even this tends to understate the amount of fiscal austerity that Iceland has engaged in. This is because it includes the increase in spending attributable to rising interest payments on the national debt. To get a proper idea of the amount of fiscal austerity that Iceland has engaged in (i.e. cuts in direct spending and increases in taxes) one has to look at the general government cyclically adjusted primary balance which can be found in Table A4.  Iceland’s general government cyclically adjusted primary balance rose from a deficit of 6.9% of potential GDP in 2009 to a surplus of 6.2% of potential GDP in 2014, or a change of 13.1% of potential GDP.

How does this compare with other countries? The following graph shows the change in general government cyclically adjusted primary balance between 2009 and 2014 for 33 advanced nations, plus the Euro Area as a whole, and the four emerging economies of Croatia, Hungary, Poland and Romania that also happen to be EU members. (It turns out that 2009 is a good base year since the cyclically adjusted primary deficits of most advanced nations peaked that year.)

Sadowski Iceland

By this standard Iceland has done about 30% more austerity than Ireland, over double that of the UK, roughly three and a half times as much as the US, and approximately five and a half times as much as Latvia. The only country that has done more fiscal austerity is Greece.

None of this should come as a surprise. When nearly all the other OECD members were busy implementing fiscal stimuli in early 2009, Iceland (joined only by Ireland) was engaged in a massive fiscal consolidation (see Figure 3.2 and Table 3.1).

In 2012 the Icelandic Finance Ministry, in front of an audience of fellow OECD senior budget officials, patted itself on the back for a job well done.

The scope and scale of Iceland’s fiscal consolidation was truly mind boggling. Real primary expenditures were estimated to fall by 12.7% between 2009 and 2012 (Slide 16). This was accomplished by slashing current expenditures, transfers, and maintenance and investment, and by freezing public sector wages and benefits for a period of four years (Slide 13), during a time when inflation soared due to the 50% depreciation of the króna.

On the revenue side the VAT was raised to 25.5%, which at that time was the highest in the world (Slide 14). The top personal income tax rate was increased from 35.7% to 46.2% (Table 2):

The capital income tax rate was doubled from 10% to 20%, the corporate income tax was increased from 15% to 20%, the social security contribution (SSC) was increased from 5.34% to 8.65% and fishing levies (important in Iceland) were increased. In addition a whole slew of new taxes were imposed (e.g. a net wealth tax, an inheritance tax, a financial activities tax (FAT) etc. etc.)

The bottom line is that Krugman’s implied poster child for anti-fiscal austerity is in reality the advanced world’s second leading practitioner of it. If Iceland’s economy is doing as well as Krugman claims (I have my doubts), then the only real reason it is doing so well (we have yet to see what happens after capital controls are lifted) is relatively steady NGDP growth as demonstrated in Scott’s post.

Thus it seems to me that Krugman’s recent posts extolling the relative economic performance of Iceland are inadvertently strengthening the argument for the ability of monetary policy to wholly offset fiscal policy.

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To Yanis Varoufakis, the “EZ bed” is not comfortable!

The problem is simple: Greece’s creditors insist on even greater austerity for this year and beyond – an approach that would impede recovery, obstruct growth, worsen the debt-deflationary cycle, and, in the end, erode Greeks’ willingness and ability to see through the reform agenda that the country so desperately needs. Our government cannot – and will not – accept a cure that has proven itself over five long years to be worse than the disease.

Our creditors’ insistence on greater austerity is subtle yet steadfast. It can be found in their demand that Greece maintain unsustainably high primary surpluses (more than 2% of GDP in 2016 and exceeding 2.5%, or even 3%, for every year thereafter). To achieve this, we are supposed to increase the overall burden of value-added tax on the private sector, cut already diminished pensions across the board; and compensate for low privatization proceeds (owing to depressed asset prices) with “equivalent” fiscal consolidation measures.

The view that Greece has not achieved sufficient fiscal consolidation is not just false; it is patently absurd. The accompanying graph not only illustrates this; it also succinctly addresses the question of why Greece has not done as well as, say, Spain, Portugal, Ireland, or Cyprus in the years since the 2008 financial crisis. Relative to the rest of the countries on the eurozone periphery, Greece was subjected to at least twice the austerity. There is nothing more to it than that.

Not so fast Yanis! I concur that largely, the EZ crisis was mostly an NGDP (i.e. monetary crisis). The charts show that clearly. (Note: the scale is the same in all charts)

Yanis Complains_1

Greece has not done as well as Spain or Ireland mostly because initial conditions in Greece were much “worse”. While Spain and Ireland were forcefully reducing their government debt ratios before the crisis, reaching debt ratios of less than 40% and 30%, respectively, Greece´s debt ratio remained at the 100% level.

Also, Greece had the highest structural deficit relative to potential GDP going into the crisis, so naturally, Greece had to be more “austere” than either Ireland or Spain. There´s also the fact that Greece´s credibility is extremely low!

Yanis Complains_2

Later, YV writes:

Following Prime Minister David Cameron’s recent election victory in the United Kingdom, my good friend Lord Norman Lamont, a former chancellor of the exchequer, remarked that the UK economy’s recovery supports our government’s position. Back in 2010, he recalled, Greece and the UK faced fiscal deficits of more or less similar size (relative to GDP). Greece returned to primary surpluses (which exclude interest payments) in 2014, whereas the UK government consolidated much more gradually and has yet to return to surplus.

At the same time, Greece has faced monetary contraction (which has recently become monetary asphyxiation), in contrast to the UK, where the Bank of England has supported the government every step of the way. The result is that Greece is continuing to stagnate, whereas the UK has been growing strongly.

Not quite true. In 2010, Greece´s Structural Deficit relative to potential GDP was about 50% higher than Britain´s, but I agree that Greece has experienced “monetary asphyxiation”. The UK is fortunate to have an independent monetary policy!

Yanis Complains_3

Bottom Line: If Greece was willing to “get in bed” with the likes of Germany, now it must try to become more like them, and if that´s not palatable…

Lars Christensen has a post on Yanis.