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Depression-creating macroeconomics

Martin Feldstein is by no means a radical economist. He advised President Reagan and is a former President of the NBER.  But even he warns of the peril implicit in the failure to distinguish structural from cyclical deficits in the European economies.  Moreover, this failure seems implicit in the stance of the European Central Bank.  The failure risks massive European unemployment and depression. Quote from the excellent Project Syndicate blog:

“European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression. To understand why, it is useful to compare how European countries responded to downturns in demand before and after they adopted the euro.

Consider how France, for example, would have responded in the 1990’s to a substantial decline in demand for its exports. If there had been no government response, production and employment would have fallen. To prevent this, the Banque de France would have lowered interest rates. In addition, the fall in incomes would have automatically reduced tax revenue and increased various transfer payments. The government might have supplemented these “automatic stabilizers” with new spending or by lowering tax rates, further increasing the fiscal deficit.

In addition, the fall in export demand would have automatically caused the franc’s value to decline relative to other currencies, with lower interest rates producing a further decline. This combination of monetary, fiscal, and exchange-rate changes would have stimulated production and employment, preventing a significant rise in unemployment.

But when France adopted the euro, two of these channels of response were closed off. The franc could no longer decline relative to other eurozone currencies. The interest rate in France – and in all other eurozone countries – is now determined by the European Central Bank, based on demand conditions within the monetary union as a whole. So the only countercyclical policy available to France is fiscal: lower tax revenue and higher spending.

While that response implies a higher budget deficit, automatic fiscal stabilizers are particularly important now that the eurozone countries cannot use monetary policy to stabilize demand. Their lack of monetary tools, together with the absence of exchange-rate adjustment, might also justify some discretionary cyclical tax cuts and spending increases.

Unfortunately, several eurozone countries allowed fiscal deficits to grow in good times, rather than only when demand was weak. In other words, these countries’ national debt grew because of “structural” as well as “cyclical” budget deficits.

Structural budget deficits were facilitated over the past decade by eurozone interest rates’ surprising lack of responsiveness to national differences in fiscal policy and debt levels. Because financial markets failed to recognize distinctions in risk among eurozone countries, interest rates on sovereign bonds did not reflect excessive borrowing. The single currency also meant that the exchange rate could not signal differences in fiscal profligacy.

Greece’s confession in 2010 that it had significantly understated its fiscal deficit was a wake-up call to the financial markets, causing interest rates on sovereign debt to rise substantially in several eurozone countries.

The European Union’s summit in Brussels in early December was intended to prevent such debt accumulation in the future. The heads of member states’ governments agreed in principle to limit future fiscal deficits by seeking constitutional changes in their countries that would ensure balanced budgets. Specifically, they agreed to cap annual “structural” budget deficits at 0.5% of GDP, with penalties imposed on countries whose total fiscal deficits exceeded 3% of GDP – a limit that would include both structural and cyclical deficits, thus effectively limiting cyclical deficits to 3% of GDP.

Negotiators are now working out the details ahead of another meeting of EU government leaders at the end of January, which is supposed to produce specific language and rules for member states to adopt. An important part of the deficit agreement in December is that member states may run cyclical deficits that exceed 0.5% of GDP – an important tool for offsetting declines in demand. And it is unclear whether the penalties for total deficits that exceed 3% of GDP would be painful enough for countries to sacrifice greater countercyclical fiscal stimulus.

The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situations” outside the control of governments.

If this language were adopted, it would eliminate automatic cyclical fiscal adjustments, which could easily lead to a downward spiral of demand and a serious depression. If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5% of GDP.

If France must remove that cyclical deficit, it would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers – and thus a bigger fiscal deficit and calls for further fiscal tightening. It is not clear what would end this downward spiral of fiscal tightening and falling activity.

If implemented, this proposal could produce very high unemployment rates and no route to recovery – in short, a depression. In practice, the policy might be violated, just as the old Stability and Growth Pact was abandoned when France and Germany defied its rules and faced no penalties.

It would be much smarter to focus on the difference between cyclical and structural deficits, and to allow deficits that result from automatic stabilizers. The ECB should be the arbiter of that distinction, publishing estimates of cyclical and structural deficits. That analysis should also recognize the distinction between real (inflation-adjusted) deficits and the nominal deficit increase that would result if higher inflation caused sovereign borrowing costs to rise.

Italy, Spain, and France all have deficits that exceed 3% of GDP. But these are not structural deficits, and financial markets would be better informed and reassured if the ECB indicated the size of the real structural deficits and showed that they are now declining. For investors, that is the essential feature of fiscal solvency”.

10 comments to Depression-creating macroeconomics

  • derrida derider

    Yes, Martin Feldstein is a true freshwater economist. But clearly he retains some intellectual integrity, unlike so many of his Chicago colleagues who said “tax cuts now because deficits don’t matter” when Bush was President and are saying “spending cuts now because we have a debt crisis” when Obama is president. Both positions were and are, of course, untrue.

  • JB Cairns

    Most of the problems of the structural deficits in Europe emanate from lack of taxation revenues.

    Martin Parkinson made the point in an Asutralian context that using the Structural deficit as a guide to what is happening to fiscal policy is useless. Our SD rose from less than 2 to over 5% yet the public secotr is detracting from growth.

    something similar in happening in some European countries

  • observa

    “Both positions were and are, of course, untrue.”
    Probably in the short run derrida, but perhaps there was method in their madness in the long run. Welcome to that now because it would appear that only a debt crisis will cure Keynesian debt addicts and money printers, whatever their stripes. We Austrian fans have wry smiles at all this nonsense now of course.

  • observa


  • observa

    Doug Noland in The Asia Times-

    “I am convinced that a capitalistic system must have a monetary anchor to be sustainable. A functioning market pricing mechanism is fundamental to resource allocation, saving and investment, wealth creation and, in the end, social stability and cohesion. Stable money and Credit is a prerequisite. One can also think in terms of two distinct pricing systems. There is the pricing of goods and services throughout the ”economic sphere.” There is, as well, the pricing of finance/Credit/risk in the ”financial sphere.” It is the pricing mechanism within the financial sphere that has become so badly out of whack to the point of posing dire risk to global Capitalism.

    As I’ve noted in the past, we live in period unique in financial history: There is globally no limits placed on the quantity or quality of Credit creation. There is no gold standard; no Bretton Woods monetary regime; nor even an ad-hoc ”dollar standard” working to regulate global Credit expansion. Markets for pricing finance and risk have turned progressively distorted and, in the end, dysfunctional. This was a predictable outcome for a global ”system” bereft of a monetary anchor. Policymakers have repeatedly responded to dysfunction and inevitable booms-turned-bust with unprecedented market intervention. This continues to only exacerbate financial market pricing distortions and attendant imbalances. What began as tinkering has regressed to the point of policymakers attempting to take virtual command over the pricing of finance. Capitalism now hangs in the balance.

    I am prepared to defend Capitalism until my dying days. I expect this endeavor to be no less of a challenge than it’s been the past 12 years trying to explain the great dangers associated with a runaway Credit Bubble. Over the long-term, for Capitalism to succeed in the real economy requires a functioning pricing mechanism and sound Credit system. Distorting the price of finance ensures speculative Bubbles, the misallocation of real and financial resources, and resulting economic maladjustment. In this regard, policymakers have bordered on gross negligence.

    Massive fiscal and monetary stimulus, along with unprecedented market interventions, has completely overwhelmed the capacity of the markets to effectively price risk. Instead of learning from past mistakes, policymakers are more determined than ever to dictate market pricing. Rather than recognizing the prevailing role ”activist” central banking has played in fomenting dysfunctional markets, policymakers believe market outcomes beckon for only greater activism. Until governments can begin to extricate themselves from the manipulation of interest rates and risk market pricing more generally, this long cycle of destructive booms and busts will run unabated.”


  • JB Cairns

    you Austrians should be apologising all the time.

    most of the problem European nations have brought down quite harsh austerity budgets.

    Austrians believe this will lead to increased economic growth.

    Those who actually understand economics said at the time contractionary policies will bring on economic contraction and it did.

    Remarkable, you reduce growth bring on a recession and surprise surprise both the debt and deficit ratios increase.

  • observa

    “most of the problem European nations have brought down quite harsh austerity budgets.”

    And why have they had to do that?
    Ans: Because the cart can’t push the horse any longer.

  • observa

    We told you it would happen and why but we just couldn’t tell you when. WHEN!!!

  • JB Cairns

    They didn’t have to do it but they did ignore Keynes and his advice on fiscal policy in good times.

    you have conceded austerity at the wrong times merely brings on recessions.

    Markets started changing their pricing of risk in 2007.

    That was one of the consequences of the credit crunch

  • observa

    It’s all demographics. When you printed money for young BBers in the 70s they spent it straight away and rapid inflation occurred coupled with unprecedented unemployment bacause there was no way economies could cope with the influx into the workforce, particularly with the nos of women putting their hands up. By the time that had been wound out of the system in the 80s (cue Volcker and Co) the economies kicked into gear properly with innovative ways of necessarily financing new family formation, the dotcoms and the takeover of capital in general. What began as necessary financial innovation grew into the greatest Madoff scheme (Ponzi was an amateur) the world had seen. With the money printing going on everywhere that should have produced some significant inflation but cue Chinese mercantilism and predatory lending to assuage that while the Madoff and Central Bank dough went into inflating asset prices. The BBers are retiring now and that fools gold has to be unwound and unwinding it is. Without Govt warehouses, silos, tanks and bunkers full of real material savings what else can happen? That’s not Keynes’ fault nor is it a Minsky moment, but it could never have happened with a real anchor in the medium of exchange, unit of account or store of wealth. Fools gold it is now, which is why a generation knows it must make real savings now or else retirement will be grim. The public sector, which includes so many BBers has also been bloated way beyond the next generation’s capacity to pay and it shows. That liability cannot continue either. Hence the cart can’t push the horse any longer.

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