A Sudden Reversal of Fortunes

Tuesday, 21 September 2010 13:00 By Paul Krugman, Krugman & Co. | name.

A Sudden Reversal of Fortunes
(Image: Hajo, studiohajo.nl / CAI/NYTS)

Back in May I fulminated about an outlook report released by the Organization for Economic Cooperation and Development, which followed up on its suggestion that the United States Federal Reserve should raise interest rates.

Sadly, the Paris-based O.E.C.D. is Conventional Wisdom Central. And so it dutifully relayed the opinion that advanced nations should indeed start cutting spending and — even more remarkably — raise interest rates right away. As I pointed out back then, this made no sense even in terms of the O.E.C.D.’s own fore- casts, which predicted that unem- ployment would remain very high in the United States and inflation would remain very low for years to come. Basically, when the O.E.C.D. was predicting 8.4 percent unem- ployment and 1 percent inflation at the end of 2011, raising interest rates in 2010 would have been a violation of everything we know about sensible monetary policy.

The O.E.C.D. never explained why fiscal contraction should take place while the economy was still deeply depressed, though it offered some vague appeals for market confidence. Now, four months later, the O.E.C.D. has changed its mind. Maybe hold off on those interest rate hikes, it says in its latest economic outlook, which was released on Sept. 9. And if things get really bad, maybe delay the fiscal austerity.

So why the reversal? This new report is presented as a response to a change in forecasts for the world’s seven largest economies. According to the report: “Recent high-frequency indicators point to a slowdown in the pace of recovery of the world economy that is somewhat more pronounced than previously anticipated. Against this background and according to the O.E.C.D. short-term forecasting models, growth could slow in the G-7 economies to an an- nualized rate of about 1.5 percent in the second half of the year. There is nevertheless great uncertainty in the outlook arising from a combina- tion of weaknesses and strengths.”

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But the slowdown we’re seeing now isn’t surprising. Everyone who took a Keynesian approach seriously has long been very worried about the second half of 2010. In December of last year I noted that the effects of stimulus spending on gross do- mestic product follow an inverted U: the peak effect on the level of G.D.P. comes at the top of the curve, but the peak effect on growth comes earlier, before the curve flattens out. When spending tails off, the effect on growth turns negative.

In May the O.E.C.D. was respond- ing to social pressure, not economic logic. All the right people wanted austerity now, because, well, just because. So the O.E.C.D. went along. Now, bad economic news has led the organization to realize that there’s nothing supporting its position.

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BACKSTORY: In Europe, Contradictory Advice

On Sept. 9, the Organization for Economic Cooperation and Development, a think tank rep- resenting 33 countries, issued a report revising an earlier, brighter outlook for the global economy, causing alarm in some quarters.
Specifically, the O.E.C.D. pre- dicted that growth in the world’s seven largest economies would slow by year’s end — not the sort of news countries within the European Union have been hoping to hear following years of belt-tightening.

And the O.E.C.D.’s remedy might be even less welcome in nations that have implemented harsh austerity measures: If prolonged, the slowdown could warrant additional monetary stimulus and, “where public finances permit, planned fis- cal consolidation could be de- layed.” Nevertheless, despite the O.E.C.D.’s recommendation that nations loosen their purse strings, in its September report the European Central Bank continued to insist that govern- ments in the European Union focus on budget reductions until deficits drop below 3 percent of gross domestic product.

But some economists have warned that ongoing fiscal contraction might leave public coffers empty and much-need- ed welfare programs impov- erished, and that without ap- propriate monetary stimulus such fiscal restraint might even cause a double-dip recession. The E.C.B., however, has in- dicated that the market confi- dence that austerity engenders is worth the risk.

The news from the O.E.C.D. was not all grim. Britain actu- ally received an upgraded fore- cast for third-quarter growth, from 0.5 percent to 0.7 percent -making it the fastest-growing economy within the Group of 7 nations, which also includes the United States, Germany, Ja- pan, France, Canada and Italy -though this rate of growth would still fall behind that of the nation’s second quarter. 

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008.

Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including "The Return of Depression Economics" (2008) and "The Conscience of a Liberal" (2007).

Last modified on Tuesday, 21 September 2010 15:42