Paul Krugman has posted an interesting and concrete analytical comment (Phantom Crises”) in reply to my October 3 op-ed in the Financial Times “Britain should not take its credit status for granted”. Prof Krugman explained why he never felt any need to temper his famously strong advice to the UK government to massively raise borrowing, even though he simultaneously believed (and widely opined) that the Eurozone might very well soon blow up.
I should also thank Simon Wren-Lewis for his response: he recognised that my op-ed clearly was not intended as a piece of advocacy to justify the UK’s exact policy trajectory. In fact, I point to several areas where it could have been significantly improved, for example, greater infrastructure spending. I am, however, arguing that the insurance elements of the problem need to figure more prominently in the discussion.
Prof Krugman’s comment, using a simplified version of the canonical modern IS-LM macroeconomic model, shows that even if a euro collapse would have led to a run on sterling, the result would be depreciation of the pound and a rise in demand for British traded goods. At the same time, he argues that even if this built-in automatic stabilizer were not enough to prevent a “squeeze” on long-term bonds, the Bank of England could just print money and buy them up en masse thanks to the liquidity trap. (Prof Wren-Lewis, who Prof Krugman cites, also makes this point.) Thus there was in fact no need to reconcile his debt management advice with his euro red alert.