Economists squabble over how to best assess recovery data

Iceland has been used by Nobel laureate Paul Krugman as a poster child for economic recovery. But Stefan Karlsson again argues--this time with help from the Council on Foreign Relations--that Baltic countries may have better overall numbers.

Tobias Schwarz/Reuters
German Chancellor Angela Merkel (right) welcomes Iceland Prime Minister Johanna Sigurdardottir for the "Council of the Baltic Sea States" leader summit in Stralsund in this May 2012 file photo. Paul Krugman often uses Iceland as a model of European recovery. But Stefan Karlsson argues that some Baltic states have actually shown greater improvement.

The Council on Foreign Relations have published an article which criticizes Paul Krugman and other Keynesians for using Iceland as a role model because GDP has dropped by less compared to the pre-crisis peak than the Baltic countries.

Their argument is basically that it is wrong to simply take the pre-crisis peak in output as the standard, one should also consider how big the preceding boom was. And since the Baltic countries had far higher growth than Iceland, especially by the way if you adjust for population growth which they didn't, before the slump their long term performance is better.

Are they right to do so? Well, what one should remember is that the purpose of this discussion is to determine whether devaluation and inflation is effective in fighting a recession. In order to do so, one needs an idea of how big the slumps would have been without devaluation, and one indicator of that is how big the imbalances before the slump were. The bigger Baltic boom is an argument for believing that the imbalances were greater there, though it is unclear to what extent

That is a point that Ryan Avent of the Keynesian The Economist magazine seems to have grasped, though he dismisses the higher previous growth as simply reflecting that the relatively poor Baltic countries were benefiting from the catch-up effect that poorer countries often benefit from.. But while that probably was one factor benefiting those countries, their relative poverty also meant significant emigration even before the slump something that in turn meant that their population dropped while Iceland's increased by 13% between 2000 and 2011. Taking population growth in to account both means that their initial boom was much bigger than GDP growth suggests and that the drop in living standards during the slump have been smaller.

Paul Krugman, apart from quoting Avent's argument, have no real arguments except that if one sees the Baltic recovery as impressive one should also see the U.S. economy in 1934 as impressive because growth was 10.9% in 1934.

But the CFR argument didn't simply depend on growth in the recovery, it looked at total growth in the whole period consisting of initial boom, slump and recovery, so Krugman's response was to an argument that wasn't made and he therefore didn't respond to the argument that was made, namely that just as it could be the case that a bigger slump could enable higher growth in the recovery, a bigger boom will mean a bigger slump to the extent the boom rested on larger imbalances.

And both Krugman and Avent fails to notice the fact I pointed to in my previous post on the subject, namely that virtually the entire Icelandic slump came after its 2008 decalcuation and that the mild recovery of the latest year came only years later-after the currency had stabilized. This fact illustrates the theoretical point that except during periods of secondary deflation, like during the 1930s depression , devaluation is in fact not something that boosts economic growth.

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