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Transatlantic Strife

NEW YORK  A public spat has erupted between New York Times-columnist Paul Krugman and European Commission officials. For weeks Krugman has been heaping scorn on EU commissioner Olli Rehn, who is responsible for economic and monetary affairs, singling Mr Rehn out as the symbol of the eurozone’s – in his view misguided – austerity drive.

Not only did Mr Krugman assail commissioner Rehn for his claim that – thanks to the eurozone’s austerity measures – calm had been restored on financial markets, but also for his assertion that high government debt levels pose a significant drag on a country's economic growth, hindering economic recovery. Mr Krugman dismissed this as “cockroach ideas,” – “ideas that you try to flush away, but keep coming back,” even though Olli Rehn based his claim on research by Kenneth Rogoff and Carmen Reinhart, two renowned Harvard professors.

The spokespersons of the European Commission took to Twitter in defense of the economic and monetary affairs commissioner. Director of Communications Koen Doens wondered aloud whether the Nobel laureate would next resort to "spitting" and Ryan Heath, spokesperson of commissioner Kroes, criticized Paul Krugman for his "unimpressive" performance in 2009 when he was invited to Brussels to give actual crisis ideas. EU commissioner Neelie Kroes, responsible for the digital agenda, tweeted that the single market and the EU are the biggest "cockroaches" – they will not go away.

It is quite telling that Ms Kroes fails to dub the euro a cockroach, but this as an aside.

According to Mr Krugman, financial markets’ calm has been restored thanks to Mario Draghi, the European Central Bank’s president, who in July of last year promised to do everything needed to prevent a break-up of the euro area. Financial markets have since been euphoric, with the Dow breaking all-time records and yields on peripheral government bonds dropping sharply. Confidence in the eurozone seems to have returned.

What Paul Krugman conveniently fails to mention, however, is that Mr Draghi’s intervention was only possible because the countries of the European Union, with the notable exception of the United Kingdom and the Czech Republic, had agreed to the so-called fiscal compact, which sets standards for budget deficits and debt-to-GDP ratio’s. Without the fiscal compact there would undoubtedly have been insufficient support within the ECB for the Outright Monetary Transactions program, better known as OMT, which gives Draghi the authority to buy up unlimited amounts of bonds of eurozone countries in need.

More importantly, the OMT is inseparable from the austerity measures that Mr Krugman so despises, since any purchase of government bonds by the ECB is contingent on the issuing country agreeing to an austerity program with either the European Financial Stability Facility, or its successor, the European Stability Mechanism.

Paul Krugman believes that if governments boost spending in the aftermath of a housing bubble to offset the collapse in private spending, the economy will recover on its own and grow sufficiently for government debt levels to be sustainable. In his view the current economic recession is simply the result of a lack of demand, with no role for the supply side of the economy.

In reality, housing bubbles come with Dutch disease-like symptoms, i.e. a deterioration of the tradable sector. Debt-financed government spending to offset the collapse in private spending will mainly benefit the non-tradable sector, and hence, prolong the problems in the tradable sector.

Much of the imbalances within the eurozone involved trade with non-euro countries. Germany saw a sharp increase in the exports to Asia and Eastern Europe, because of strong demand for German durable manufactures. Southern Europe, on the other hand, experienced a sharp increase in imports from low-wage countries. For southern Europe to regain its competitiveness, internal devaluation is as necessary as it is painful. Debt-fueled public spending will only delay the much-needed adjustment, posing indeed a drag on the economic recovery.

It would be nonsensical for Germany to prize itself out of the market, as Mr Krugman has suggested more than once, to meet the periphery halfway. A better course of action would be to focus on debt restructuring and reinforcement of the tradable sector in the periphery.

Internal devaluation generally leads to a lower GDP, and therefore to a higher debt-to-GDP ratio. For internal devaluation to succeed and to offer peripheral countries a chance to start with a clean slate, it must be accompanied by a restructuring of sovereign debt. This will come at the expense of banks in the core countries of the eurozone, such as Germany and the Netherlands, but that's only deservedly so. After all, the banks should not have lent money on such a large scale at such low interest rates to the eurozone’s periphery in the first place.