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OECD Economic Outlook: “Disconnected from real needs”?

June 2, 2010

Last week, we reported on the latest OECD Economic Outlook. Writing in the New York Times, Paul Krugman was highly critical of the Organisation’s analyses and policy recommendations. Here we summarise Krugman’s argument and the reply by OECD Deputy Secretary-General and Chief Economist Pier-Carlo Padoan.

Krugman argues that the most ominous threat to the still-fragile economic recovery is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.

He contrasts this with actions taken when the financial crisis first struck, and most of the world’s policy makers responded by cutting interest rates and allowing deficits to rise.

He goes on to say that “The extent to which inflicting economic pain has become the accepted thing was driven home to me by the latest report on the economic outlook from the Organization for Economic Cooperation and Development… what [the OECD] says at any given time virtually defines that moment’s conventional wisdom. And what the OECD is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.

What’s particularly remarkable about this recommendation is that it seems disconnected not only from the real needs of the world economy, but from the organization’s own economic projections.”

His demonstration is as follows. The OECD declares that interest rates should rise sharply over the next year and a half to head off inflation, but inflation is low and declining, and OECD forecasts show no hint of an inflationary threat.

The reason the OECD wants to raise rates is in case markets start expecting inflation, even though they shouldn’t and currently don’t.

Likewise, although the OECD predicts that high unemployment will persist for years, it asks that governments cancel any further plans for economic stimulus and that they begin fiscal consolidation next year.

Krugman insists that both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because a weaker economy depresses tax receipts, wiping out any gains from governments spending less.

Moreover, the reasons for doing this don’t hold. Investors aren’t worried about the solvency of the US government and interest rates on federal bonds are near historic lows. And “even if markets were worried about U.S. fiscal prospects, spending cuts in the face of a depressed economy would do little to improve those prospects”.

This contrasts with the OECD’s calls for cuts because inadequate consolidation efforts “would risk adverse reactions in financial markets.”

Krugman is worried that this view is spreading, citing the case of “conservative members of the House, invoking the new deficit fears, [who] scaled back a bill extending aid to the long-term unemployed… many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.

He concludes by stating that “more and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.”

In reply, Padoan starts by saying that they differ on the strength of the recovery, with the OECD more optimistic than critics of the Outlook. Unemployment will take time to fall to acceptable levels, but this will be underway by 2011. A double-dip recession cannot be ruled out, but is not very likely. The risks of running big fiscal deficits and a zero interest rate monetary policy are rising.

Recent events in Europe are a warning sign and even though the US has the world’s biggest capital market, the risks are shifting. In this unsettled financial environment, governments need to get out ahead of markets, because otherwise they will be hostage to them.

On inflation, he argues that it is not a risk today, but could be in two-years’ time. Monetary policy needs to be forward looking and this means easing up on monetary stimulus in anticipation.

“To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags.”

How quickly interest rates should rise depends on many things, especially inflation, inflation expectations and the pace of growth. It also depends on fiscal policy, which influences growth.

“All else equal, if fiscal policy turns out to be tighter than in our projection, then monetary policy should be looser to compensate.”

Useful links

OECD Economic Outlook

8 Responses leave one →
  1. June 2, 2010

    About 70% of the U.S. GDP consists of consumer spending. Consumers are not in a position of strength to drive the economy right now, and investments take a while to reap benefits.

    Therefore, contraction in government spending can be dangerous. Increased government spending does not necessarily guarantee inflation (well, based on the data I’m looking at).

    Unfortunately, debates like these tend to present either/or choices when the solution might involve a number of elements. For example, citizens need the immediate relief a stimulus can provide, and the government needs to make targeted investments in industries that will be the “next big thing” to ensure future economic growth…

    In any case, the solutions are not easy…

    song currently stuck in my head: “fairy tales” – the crusaders

  2. June 3, 2010

    “To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags.”

    I agree, and I suspect Paul Krugman would agree, with the idea that, normally, stimulus should be progressively reduced during a recovery. The optimal target for the federal funds rate rises as the economy moves closer to the (uncertain) NAIRU. At the trough of the recession, the optimal target was something like negative six percent. It has risen since then, and if the recovery continues, it will continue to rise. The question is when it will rise above zero. I don’t think Padoan has made much of a case that that will happen any time soon.

  3. June 3, 2010

    Sometime back. there was a reference that progressive reduction of stimulus during a shaky recovery may look like ‘fanning a flame’. However adding stimulus further on top of unsustainable deficits may prove to be worse in the long term (signs of it surface in market). Agreeing that progressive reduction of stimulus during a shaky recovery is like fanning a flame; I also believe continuing this easy money policy can be more devastating (like adding fuel in the flame for the medium to long term).

    However who thinks for the long term (remember Keynes). And how long is long term depends on the perspective of sustainability.

    Krugman seems to be not satisfied (his response to this article). However I believe depending on the situation (country specific), there’s need to progressively reduce stimulus, or even tighten monetary policy. Look at China and India. They are the victims of easy money policy in US or Europe.

    A global approach in monetary policy would have been better ((though China demands easy money policy in US/Europe to stay as they can export more to these regions). However exporting capital has always been the prerogative of rich nations.

  4. Adam permalink
    June 3, 2010

    If I didn’t know better I would think the post above was mocking the weakness of your argument. You want to base policy over what ‘could’ happen? Over what the stock market might want in the future? Maybe we will have high inflation in a couple years, maybe high deflation. A 3-4% inflation rate would be a positive outcome. Wages and home values would inflate, thus easing the recession and housing bubble. But how do you even have that, let alone a dangerous level of inflation, with 10% unemployment? There aren’t even any signs of creeping inflation. Inflation can only happen if the money generated by all the quantitative easing is lent out by the banks holding it and spent by consumers. That would end the liquidity trap and the recession along with it. What a terrible outcome.

  5. Pertti permalink
    June 5, 2010

    Somehow Pier-Carlo Padoan seem to be confusing money-issuing-authority with one that is fundamentally restricted in that sense, such as Greece. The division is drastic: other can always honor it’s nominal liabilities, while other can not. In other words, while Greece can go bankrupt normal states can not, and there is no market panic in bond markets. Japan’s and US’s treasuries trade at incredibly low levels, for example.

  6. June 19, 2010

    The Swedish Local Government Debt Office Chief Economist: Therefore is global GDP decline or W-dip not the main scenario
    As The Swedish Local Government Debt Office and part of the public sector, we have drawn attention to the sector’s financial challenges in different countries. Recently, we initiated an increased interaction at European level through the formation of the European Association of Public Bank (EAPB) ”Chief Economist’s Network” for Europe’s leading chief economists. The network aims to from a financial point discuss important issues affecting the sector, our country and the future of Europe.
    In Varna Bulgarian met chief economists of the network for the first time in which even the EU-commission leaders participated in the discussions. Meeting agenda was the public sector, the European countries and the banks’ financial situation and challenges in perspective short and long term.
    After the financial crisis, global financial economy has stabilized and begun a vigorous recovery. This applies to several countries in Europe, Asia, Australia, Russia, and South America but also in Africa. This year China’s GDP expected to grow by 10 percent, India with 8 percent and Africa with 5 percent.
    Right now it’s a big focus on our own Europe. The primary basis for the EU on a financial structure in which the interaction eurozone crisis has highlighted clear deficiencies in the cooperation arrangement. The world changes at an accelerating rate, but what unites us is to go to new challenges such as globalization, urbanization and the financing of future prosperity.
    In fact, many of the world’s countries and economies have fewer and fewer young people, while the proportion of elderly is increasing sharply. Exit strategies and eurozon crises is not just about public debt, but about our future and welfare.
    What started as a financial crisis in the United States ended with a small country in Europe with 2.5 percent of EU GDP, triggered an eurozon crises. But the crisis also opens up for interesting discussions about our future. For the question is how the European countries can reduce their public debts while creating new growth.
    Substantial increases in public debt are not a new phenomenon. Both Sweden and Finland have been in several crises in recent decades but managed to escape in a financially efficient manner while growth is greatly increased. Both countries were also selected as good examples for our meeting with European Commission leaders.
    How can Europe’s future look like?
    Participants at the meeting of the Chief economist Network saw a stabilization and moderate recovery of European finances. Even given the enormous financial restructurings that must now be implemented.
    If the EU countries’ financial consolidation handled efficiently as there is already good examples in the public sector, the short-term negative effects on growth and limited long-term effects become significant. In particular, the consolidation credibly perceived as permanent.
    Euronzon crises will lead to necessary reforms of the Stability and Growth Pact in which the crisis contributes to a more integrated Europe, but also increase the EU monitoring of the macro-economic imbalances in the country. The unique rescue package made up of the ECB, the IMF and the euro countries is a major step in improved coordination and financial cooperation between the countries.
    Rescue Package is a step where the strong economies such as Germany will help the weaker such as Greece. What many may not think of is that some relief is already available today via the European Structural Funds. Something that Sweden also takes part of.
    In order to avoid new crises and deficits, it is important to starp fiscal discipline. Macro-economic imbalances also need to outlying farm to increase long-term competitiveness. There is a clear need for a permanent and much clearer framework for dealing with crises, which turned out not to exist.
    Last and most important to prevent a global fall in GDP, or double-dip in exit strategies and budgetary consolidation, a consensus of world leaders on how to strengthen the global recovery.
    For a common vision is the key word in countries’ public finances should be stabilized while growth must increase. The fact is that all countries can not launch their savings package at the same time – when there is a risk that growth is affected adversely.
    Now it is about ensuring sustainable public finances, and increase the GDP growth potential. This should be done through a reform of the Stability and Growth Pact framework with an implementation of the new European strategy in 2020 will be an important factor.
    I see the continuing positive developments on which a global fall in GDP, or double-dip is not the main scenario. Some countries in the world are facing enormous financial challenges and other has a very strong economy.
    A new world order is implemented. The economic history can be divided in the world before and after the financial crisis. In one year the world’s financial assets decreased by 40 billion Dollars..
    Established economies who has so far been acted as the strong and decline of the stabilizer were found to be a very unstable foundation. The rational Wall Street was far more risky than Shanghai and the stability of the euro zone turned out to contain hidden deficit.
    There is a shift of momentum and power that is impossible to ignore. We speak of a beginning of a new world order. The most important thing to learn from the financial crisis is that there is no longer a single economic and political panacea. There are several.
    The challenge is to turn weaknesses into strengths and collaborate across borders to provide our residents increased welfare and thus better quality of life. Increased financial cooperation gives simply participation on the fire and effective, something that will benefit us all.
    Lena Bäcker
    Chief Economist
    Kommuninvest in Sweden
    The Swedish Local Government Debt Office

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