This is a very good paragraph from Paul Krugman:
One last point: the Germans are very proud of their own adjustment between the late 1990s and 2007, during which they emerged from economic doldrums and became very competitive. But that adjustment, from a European point of view, looked like my first figure: German belt-tightening was accompanied by what amounted to a highly expansionary monetary policy, which led to fairly high inflation in Southern Europe. So when Germany asks why other countries can’t do what it did, it isn’t just forgetting that we can’t all run trade surpluses; it’s also insisting that other countries replicate its success while denying them the kind of external environment that made its success possible.
One small quibble, which I think even Krugman would accept. Replace “highly expansionary monetary policy” with “relatively expansionary monetary policy.” Highly expansionary is 1965-81. It was relatively expansionary compared with the post-2008 policy.
Krugman also seems to slightly modify his earlier claim that the zero-bound model has applied to the eurozone in recent years:
But as Wren-Lewis says, that’s not what has happened in Europe — the ECB has in fact been very reluctant to pursue expansionary policies despite all that fiscal austerity, and now — having waited too long — it finds itself close to the zero lower bound.
That’s been my position all along; that the eurozone has not been at the zero-bound, but arrived there a few days ago, or at least is very close.
The point, which I guess we should all have been making more clearly, is that all the various things we talk about here — the extreme slump in Southern Europe, Germany’s failure to narrow its current account surplus, and the slide of the eurozone as a whole toward deflation — are really aspects of the same story. We have huge forced fiscal contraction in part of Europe, not at all offset by either overall monetary policy or fiscal expansion elsewhere.
So the ECB made a big mistake in 2011 by not offsetting fiscal austerity. Krugman and I agree on that point. The eurozone was not at the zero bound, so austerity should not have reduced demand, even using Krugman’s model. One irony here is that Krugman may be partly right about the fiscal multiplier, but for essentially supply-side reasons. One problem in 2011 was that inflation was running above target. And that was partly due to various tax and fee increases designed to close the large budget deficits. The ECB reacted to these tax increases by raising rates several times in 2011. In an AS/AD model the tax increases shifted AS to the left, raising inflation and reducing output, and the ECB reacted by shifting the AD curve to the left. So fiscal austerity was a mistake.
Or perhaps the real problem was the specific type of fiscal austerity. My analysis, combined with the ECB’s insane preference for inflation targeting, suggests that demand-side fiscal austerity would have been desirable. Raise the employee-side payroll tax by 4 percentage points and lower the employer-side payroll tax by 2 percentage points. That sort of fiscal reform would have lowered inflation and thus caused the ECB to cut rates in 2011, instead of raising rates.
But unless I’m mistaken, the Krugman/Eggertsson “paradox of toil” model suggests that my proposal to cut employer-side payroll taxes would be a mistake.
PS. Ryan Avent also has a good post on the German opposition to “inflation.”