How should we measure economic recoveries?
Iceland's recent recovery is weak, but many economists are touting it as a model of success. Does this call for more objective standards for what we can and can't hail as a 'recovery?'
After having been mired in a deep slump for years, Iceland have recently started to experience a recovery, albeit only a weak one, causing some inflationists, such as Paul Krugman, to hail Iceland as a role model and proof that devaluation works.
It should be noted however that although growth has recently been positive in Iceland, the absolute level of output remains well below the previous cyclical peak, and that the same inflationists that hail Iceland have dismissed Estonia's much stronger recovery by pointing to how Estonia's output is still below its previous cyclical peak, making their evaluations of recoveries hypocritical and inconsistent.
But leaving the issue of double standards aside, what is the correct standard by which recoveries should be evaluated. Should we compare current GDP to the level at the previous cyclical peak or to the level at the cyclical low or to some other standard?
That depends actually on what the purpose of your evaluation is. Is the purpose to assess whether or not the current state of the economy is satisfactory, or is it to assess the effects of policies implemented during the slump?
If it is the former, then the correct standard is to compare it to the level at the previous cyclical peak. And as long as output is below it, we can clearly say that the current state of the economy is unsatisfactory, which in the cases of Iceland and Estonia means that both economies still aren't good.
If it is the latter, then the correct standard is to compare it to the level before the policies were implemented .
In the case of Estonia and its spending cut programs this means comparing current output to the levels of late 2009, and since they were implemented the economy has grown fast.
In the case of Iceland, we can see that its entire devaluation (or more strictly depreciation) took place throughout 2008, and that its currency has been basically stable and in fact appreciated slightly in value since then. After having fallen dramatically more or less gradually during 2008, with the euro being worth 92 kronor in December 2007 and then falling so that it took 191 kronor to buy a euro in late December 2008, it stabilized after that so that it traded at 188 against the euro in December 2011 Yet in the first year of the devaluation (between Q4 2007 and Q4 2008), it's economy contracted by 2% and then contracted an additional 8.2% in the year to Q4 2009 and it remained in Q4 2011 6% lower than in Q4 2008 and 8% lower than in Q4 2007. We can clearly see that devaluation was followed by a really deep slump and it was only several years later, after its exchange rate had stabilized that a modest recovery started.
To the extent one should use "different standards" for assessing Iceland's and Estonia's recoveries, we can therefore see that it should be made in the opposite way that Krugman and others have done, because Estonia's spending cuts came after almost the entire slump was over and was followed by a strong recovery, while basically the entire slump in Iceland came after its currency started to depreciate and its modest recovery started only a long time later after its currency had stabilized.
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