Competitiveness: some basic macroeconomics of monetary unions

From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.

That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.

The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

Spain, and how the Eurozone has to get real about countercyclical policy

Matthew Klein has a good account of how Spain’s macroeconomic fortunes are improving, but only from a very bad place. I’m not that knowledgeable about the Spanish economy, so I cannot add any detail. However I do want to pick up on one point, which he and others (including Martin Wolf - see below) have made, which I think is wrong and misleading.

Before I do that, I just want to make a general point about the current recovery. At its heart it is export led, which is exactly what you would expect. Just as this post which compares Greece to Ireland shows, the Eurozone does have a natural correction mechanism when a country becomes hopelessly uncompetitive as a result of a temporary domestic boom (whatever its cause). The mechanism is a recession and what economists call ‘internal devaluation’: falling wages and prices. The problem with this correction mechanism is that, on its own, it is slow and painful, particularly when Eurozone inflation is so low.

So the key question is what could Spain have done to avoid having such a painful period of correction. The cause of the problem was the excess private sector borrowing of the pre-crisis period, and the associated capital inflows. This was part of an unsustainable property boom that led to a large current account deficit and rising inflation. (I liked the point that Matthew Klein made about how export orientated firms have recently increased their borrowing. Extra borrowing is not bad if the investment is sound.) What could Spain have done to cool things down? As Matthew Klein points out, Spain already had some sensible macroprudential monetary policies, and it seems likely that more of the same would not have been enough.

Which brings us of course to fiscal policy, and it is here that so many commentators go wrong. They say, correctly, that Spain’s problem was never a profligate government. They say, correctly, that the actual budget was in surplus from 2005-2007. Of course the relevant number is the underlying (cyclical adjusted) balance, and the IMF now thinks that shows a persistent although small deficit. But as Martin Wolf points out, again correctly, the IMF in 2008 thought very differently. As I have said many times in the case of the UK, ex post numbers for pre-crisis cyclically adjusted deficits can be very dodgy because of the depth and persistence of this recession.

The mistake everyone here makes is to judge the appropriate fiscal policy by the size of the deficit. That is like saying that a bigger fiscal stimulus in the US in 2009 was impossible because the deficit was already very large. For an individual country in a currency union the deficit is not the appropriate metric to judge short term fiscal policy. Unless there are very good reasons for believing the economy is too competitive, the appropriate metric is national inflation relative to the Eurozone average. From 2001 to 2007 the GDP deflator (the price of domestically produced goods) for the Eurozone as a whole increased at an average rate of just over 2%. In Spain it increased at an average rate of nearly 4%. 2% excess inflation over 7 years implies a 15% loss in competitiveness. So forget the actual budget deficit or any cyclically corrected version, fiscal policy was just not tight enough.

I have been told so many times that for Spain to have a tighter fiscal policy before the crisis was ‘politically impossible’. If that really is true, then Spain has little to complain about when it comes to the subsequent recession. If you cannot do any better, you have to leave the natural correction mechanism to do its slow and painful work. But I suspect what is ‘politically impossible’ is in part a reflection of the Eurozone’s flawed Stability and Growth pact itself, which focused entirely on deficits.

It seems more than likely that the existing monetary but not fiscal/political union is here to stay for some time. Many in Europe’s political elite plan to move quickly to greater union (see Andrew Watt here), but there are serious obstacles in their path. The current system can be made to work better, and strong countercyclical fiscal policy is an obvious part of that. Combining this with medium term deficit reduction is technically trivial. Just how many years and recessions does it take before what is obvious textbook macroeconomics can become politically acceptable?

Something we can all agree on?

Well, all economists at least. Can we all agree that public spending on maintaining and modernising public infrastructure should be increased rather than reduced in a severe recession, whatever the concerns about debt? The spending I have in mind are repairing and refurbishing state owned schools, hospitals, roads - that kind of thing.

Now all those who believe in countercyclical fiscal policy at the Zero Lower Bound will of course agree. But I think those economists who remain worried about the level of government debt should also be able to agree. The reason is that concerns over debt are almost always concerns about long run sustainability. Yet by not fixing holes in the road, or leaks in the school roof, you do nothing to improve the long run sustainability of debt. Almost certainly you are just postponing something that will have to be done sometime, and the act of postponing probably makes the eventual expenditure higher. So postponing public infrastructure investment justs shifts around the timing of public spending, and could well increase its eventually size. It does nothing to tackle issues of debt sustainability.

To see the logic of this more formally, you just have to slightly adapt the analysis in DeLong and Summers (pdf). Their model focuses on hysteresis effects from lower GDP today in reducing output tomorrow, which reduces tax receipts tomorrow etc. But public investment today, in the form of improving existing public capital, will increase output tomorrow just because public capital enhances private output. This idea is pretty standard. For example, in the European Commission’s QUEST DSGE model that I highlighted recently, whereas the long run GDP impact of permanent fiscal consolidation is generally positive for most instruments (because permanently lower government consumption eventually reduces debt and distortionary taxes), the long run multiplier from reducing public investment increases over time, as Annex 1 shows. (By the way, if you read this post, do read Jan i’nt Veld’s response in comments here.) 

There are two other reasons why shifting government spending from the future to the present is clearly a good idea in a recession. First, undertaking public investment is likely to be cheaper in a recession. Firms that will do the repairs want jobs and labour is relatively cheap. Second, to the extent that aggregate demand is a problem, shifting the pattern of public spending this way (what I call ‘pure’ countercyclical fiscal policy) is obviously a good idea. This, after all, is essentially what monetary policy is trying to do for private spending.

I am encouraged to think that nearly all macroeconomists could sign up to this by Ken Rogoff, who while clearly being sympathetic to the attempts by some governments to go in for overall fiscal consolidation, does agree that public investment should not have been cut. Why do I think this is an important point to make? Because it just might stop governments doing the opposite. I have discussed UK public investment before (or the strange attempts to get the private sector to fund public investment), and yesterday Cardiff Garcia pointed out how much US non-defense spending on structures has fallen in the last few years.

This reflects a natural tendency of politicians to do the opposite of what is sensible when they feel they have to cut back on spending. Reducing consumption spending is nearly always politically painful, but it is easier to get away with delaying repairs to (or modernisation of) schools, hospitals or highways. It was partly for this reason that Gordon Brown exempted investment spending from his first fiscal rule in 1998, even though the macroeconomic justification for doing so was debatable (see my discussion here). If all economists could sign up to saying that cutting public investment in a recession is a bad idea, whatever the concerns about debt, then just maybe politicians might think twice about doing this.  

The Eurozone’s Founding Mistake

It really was predictable. Take away the ability to control national interest rates, and you create a potential for patterns of demand to diverge, leading to movements in competitiveness that would have to be painfully unwound later on. The good news was that you could use countercyclical fiscal policy to moderate these movements - an entirely conventional macroeconomic idea. But it was not what the architects of the Euro wanted to hear.

This is how my paper just published in Global Policy starts. So instead of countercyclical fiscal policy, we got an obsession with budget deficits and the possibility of fiscally profligate governments. Even with this obsession the Eurozone failed to spot its one member that was behaving in this way until it was too late. But in looking in the wrong direction, the Eurozone allowed just the kind of competitiveness imbalances to take place that fiscal policy might have been able to do something about.

This is not wisdom from hindsight. Before the Euro was established, I was among a large group of economists suggesting that fiscal policy should be used countercyclically by Eurozone members. That work continued after the Euro was established: here and here are just two examples. It had no impact on policy. There was a lot we did not foresee. It is particularly ironic that the first major asymmetric shock to hit the Euro area, that would cause these large competitiveness imbalances, was arguably a consequence of the creation of the Euro itself. But the point remains that a method of handling these things, which was entirely conventional in macroeconomic terms, existed and was ignored.

Now in saying this I find myself in the rather unusual position of disagreeing with Martin Wolf. He has argued (here for example) that a country like Spain could not have done more in terms of fiscal policy to counteract its housing boom. I have heard many others make the same point - you think Spain should have been running even larger surpluses? they ask incredulously. The answer is simply yes: by looking at fiscal surpluses you are looking at the wrong indicator. Here is what happened to consumer price inflation from 2000 to 2007.

	2000	2001	2002	2003	2004	2005	2006	2007
Ireland	5.3	4.0	4.7	4.0	2.3	2.2	2.7	2.9
Spain	3.5	2.8	3.6	3.1	3.1	3.4	3.6	2.8
Portugal	2.8	4.4	3.7	3.3	2.5	2.1	3.0	2.4
Euro area average	2.2	2.4	2.3	2.1	2.2	2.2	2.2	2.1

 

Inflation was significantly above the Euro area average year after year. If the average inflation rate had been 10%, or even 5%, this might not have been a big deal, but when the inflation target was 2% or less, that makes reversing these trends very painful. Looking at budget surpluses during a property led domestic boom can be very misleading, as Karl Whelan argues in the case of Ireland.

There may be many reasons why the Eurozone ignored this advice. One was probably a belief among some that countercyclical fiscal policy was either ineffective or dangerous. (The ordoliberal logic on this has never really been spelt out, and it seems more like an article of faith.) Another was an almost mystical belief that the creation of the Euro would diminish the importance of asymmetric shocks or the extent of asymmetric structures.[1] Yet another was a view that the far greater danger lay in the reduced fiscal discipline that being part of the Euro would bring, and any countercyclical role would only encourage this ill discipline. Yet we now know (and I do not think anyone really foresaw this) that this last argument is completely wrong. Not having your own central bank means that market discipline on Euro members’ fiscal policy will be much greater, once it is understood that national default can occur.

I do not think this point has sunk in yet among many macroeconomists. The standard line, backed by academic papers, was that joining a common currency would reduce market discipline on fiscal policy. Yet that analysis ignored default, and the possibility of a bad equilibria generating a self-fulfilling crisis. Countries will not forget the events of 2010-12 in a hurry, so the danger now is that we have too much, not too little, market discipline influencing fiscal policy. 

Ironically, the architecture of the Stability and Growth Pact sent all the wrong signals. By stressing the dangers that individual countries might free ride on the Eurozone, it suggested that such actions might be in the national interest for any country that could get away with it. That is why attempts to control national budgets at the Eurozone level can be counterproductive as well as unnecessary. It is far better to build national institutions that can make sure countries develop appropriate fiscal policy which is in their national interest. In an ideal world the Commission might play a coordinating role, but given its current mindset it would be best if it just stayed out of the picture.

So while the details of the Euro crisis were not foreseen, the palliative medicine that would have made that crisis much more manageable was available, but those in charge decided not to take it. What turns this serious policy error into a tragedy is that policy makers continue to make the same mistake. The Fiscal Compact is exactly the opposite of what the Eurozone requires right now. (I have cited the Netherlands as a clear example of this.)

This makes me both optimistic and pessimistic about macroeconomics as a discipline. Optimistic because the subject has so much potential to do good: basic ideas, long understood, yet clearly not obvious to some, can help prevent disaster. (Those who claim that macroeconomics is the weak point of the economics family should take note.) Pessimistic because even when those disasters occur, the macroeconomic wisdom continues to be ignored.  

[1] If anything, formation of a currency union should allows greater national specialisation, which of course has the opposite effect.  

Defining countercyclical fiscal policy: a proposal

For economists

We all know what countercyclical fiscal policy is. An expansionary policy is increasing government spending, or cutting income taxes, or maybe some other tax. Oh, and its temporary, paid for by raising debt. So we have to say how the debt is financed (or maybe paid off in the future). Which means cutting future government spending, or raising future taxes of some kind. Well that makes a large number of combinations. And then there is this balanced budget fiscal expansion idea, which does not involve debt at all.

Now this multitude of possibilities would not be a problem if they all produced the same answer (the same multiplier). But they do not. I’ve talked about the various possibilities in a post before, but if you want it all done properly (as modern macro defines properly), see Denes, Eggertsson and Gilbukh (earlier version here). Now this may be fine for macroeconomists like me, because we can appear wise given this apparent confusion. But it allows others to say ‘theory is all over the place on what the multiplier is’, which is misleading. The problem is that we have not defined the policy properly.

The source of the confusion is two-fold. First, fiscal policy involves many possible instruments, and balanced budget changes in the instrument mix can have significant effects on output. Second, because a frequently discussed option involves increasing debt and never paying it off, but just paying the interest, temporary changes in one instrument can be associated with permanent changes in another. In particular, an option often considered is a temporary increase in government spending financed by a permanent increase in debt, financed by permanently higher income taxes. As I have remarked before, this policy combination is like a red rag to a bull, where the bull believes Keynesians just want to increase the size of government and raise taxes.

So how to improve things? Here is my suggestion. Let us define ‘pure’ countercyclical fiscal policy as a temporary change in some fiscal instrument, financed by changing debt, and that this debt is subsequently paid off or financed using the same instrument. So, if we raise government spending now, we payoff/finance the increase in debt by cutting government spending later (and not by raising any taxes). Now that does not make all multipliers the same, but it allows us to talk unambiguously about the government spending multiplier, or the income tax multiplier, and know exactly what we mean. Its great advantage is that, in considering the government spending multiplier for example, we do not need to address the issue of what impact any particular tax has on demand or supply at any particular time. The macroeconomics is simplified.

An alternative would be to denote one particular fiscal instrument as the residual means of finance. So, for example, it is always income taxes that pays off/finances any debt created by any particular fiscal expansion. That would also allow us to talk unambiguously about particular multipliers, but it more complicated in macroeconomic terms. We need to know what the impact of changing taxes is, even if we start by increasing government spending. Now this complication might be inevitable if policy makers have an instrument which they think of as the residual financing tool, but I do not think they do. A final problem with this approach is that it confuses two quite different issues: changing the timing of fiscal instruments, and changing their composition.

One possibly controversial aspect of my definition is that it excludes the balanced budget multiplier from the definition of countercyclical policy. But I see no problem with that. Both permanent and temporary compositional changes in the government’s fiscal mix may have important impacts on the demand for or supply of output (and inflation directly if they involve tax switches). The balanced budget multiplier is a particular type of temporary compositional change in fiscal policy.

So I like my proposed definition of pure countercyclical fiscal policy. It does not stop us analysing, or indeed recommending, more complex policy combinations, but I think any analysis would be improved by clearly thinking about such policies in two parts: a pure countercyclical policy that is just about timing, combined with some additional compositional change.

Democracy in the northern Eurozone: you can choose austerity, or austerity.

Imagine that before the US election the Congressional Budget Office published a detailed analysis of the economic implications of each candidate’s policies for different categories of government spending and taxation, and their impact on GDP, unemployment and much more. These were based on detailed and comprehensive accounts provided by both parties, and not unspecified aggregate numbers with no policies attached such as in the Ryan plan. You would have to agree that this would give voters a more informed choice, but you might also say that it was politically impossible in any country. Well have a look at the Netherlands, which will hold elections on 12^th September. That is exactly what happens there, with the analysis provided by their fiscal council, the Bureau for Economic Policy Analysis (CPB). (If you are at all interested, the detail provided in the CPB’s analysis is extraordinary (pdf) – for example, it predicts what impact each party programme will have on greenhouse emissions.)  

That is the positive news. The not so good news is that unemployment is expected by the CPB to rise by 1% over the next two years, and almost none of the major parties are planning to do anything to try and stop this. How could they stop it? Being part of the Eurozone means that fiscal policy is the only aggregate policy tool available. As a result political parties should be planning to raise budget deficits – increasing government spending or cutting taxes – on a temporary basis to keep demand rising in line with supply. Yet only one major party is planning to do this: the far right ‘Party for Freedom’, whose refusal to vote for the deficit reduction plans of the previous coalition brought down the government and sparked this election.

Now increases of 1% in unemployment may seem small beer compared to what is happening in Spain, for example. But unlike Spain, there is no market pressure in the Netherlands to reduce budget deficits. Instead the pressure comes from the Eurozone’s fiscal rules. And it matters because if countries like the Netherlands and Germany are reducing output and increasing unemployment by trying to cut budget deficits, then this makes the task for countries like Spain much more difficult.

General developments in the Eurozone are proceeding as I thought they might when I recklessly forecast that the Euro would survive. Because the process involves a power struggle between different economic ideologies, and countries, it is slow and painful and full of potential hazards and uncertainties: will the conditionality imposed on Spain and Italy to obtain ECB help be light enough to be politically acceptable to these countries, for example. (Paul Collier has an interesting post on this here.) I still worry that Germany might demand Greek exit as a token victory, but I’m relying on wise heads, and the IMF, to make sure that does not happen. However survival will still come at the price of a prolonged Eurozone recession, and here the fiscal rules are the central problem, as the Netherlands illustrates all too clearly.

The voters of the Netherlands are being given some choice, as Matthew Dalton points out . The Liberals (right of centre) want to cut the deficit by reducing spending, while the socialists want to raise taxes on high earners, and would increase the deficit compared to baseline in 2013 (but not 2014). However according to the CPB: “For almost all parties, unemployment will increase, compared to the baseline.” The exception is the right wing Freedom Party: it has the only programme that raises growth (slightly), and it is the only party that plans to increase the deficit in both 2013 and 2014 (all relative to baseline). So voters can vote against what I have previously called budget madness, but only by voting for a party that wants to abolish the minimum wage and halt immigration from non-Western countries.

I started this post with the CPB, so let me finish with them as well. The CPB is in a delicate position, as it wants to retain the trust of all the political parties for being impartial. However, in the FT (£) in February (also available here), the Director of the CPB Coen Teulings wrote an article entitled “Eurozone countries must not be forced to meet deficit targets” (jointly written with Jean Pisani-Ferry).  The Dutch central bank, on the other hand, has been calling for the urgent ‘rationalisation’ of the public finances.  (Its head was appointed by the previous coalition that proposed deficit cuts.) Which goes to show that fiscal councils tend to be wise, but central bankers talking about fiscal policy can be – well - not so wise.

Euro Deja Vu?

                I was giving a talk about the Euro crisis this week, and in preparation I looked at the new Treaty. Like Antonio Fatas I had that feeling that I had been here before. I remember reading the original Stability and Growth Pact (SGP) and wondering why the focus seemed to be entirely on debt ceilings, with no discussion of using fiscal policy as a countercyclical tool. Much the same could be said about this Treaty.

                To recap, this matters because there are two crises in the Eurozone at present: a debt crisis and a competitiveness crisis. General austerity might deal with the first, but because it includes austerity in Germany it makes the second worse: we have ‘competitive austerity’ that will lead to recession and will test the cohesion of the Eurozone. (For example, read Tim Duly and follow the links.) Both crises might have been avoided, or at least mitigated, if many non-German economies had undertaken much more aggressive fiscal tightening before 2007 as they saw their inflation rates exceed those in Germany. It is possible that the SGP itself may have discouraged such tightening, partly because politicians thought that if they were within the pact’s limits things were OK, and perhaps because of reasons I explore below.

                I cannot see anything in the new Treaty that encourages countries to think about their relative inflation and cyclical positions. If this Treaty had been in place in 2000 rather than the SGP, it seems likely that the crisis in competitiveness would still have emerged. Not only is the new Treaty unlikely to prevent such crises happening again, but it makes the current crisis worse, because there is no pressure on Germany to expand its economy by fiscal means.

                Is there anything positive to say about the Treaty? Maybe one thing. The idea of an automatic correction mechanism if deficits stray from the cyclically adjusted balanced budget rule is modelled on the Swiss and German debt brake idea. This mechanism has some attractions (see this paper by Charles Wyplosz), although I think the devil is in the detail. A debt brake with conditionality related to relative inflation rates might work, as some research I was involved with a few years ago suggests.

                The other big problem (besides ignoring countercyclical fiscal policy) which I have with the Treaty is the continuing emphasis on imposition ‘from above’. One thing that we have clearly learnt from the crisis is that it is in each country’s national interest to have adequate budgetary control. In contrast, a key idea behind the original SGP was that without it individual countries would free ride on the union, and that therefore union level control was required. This seems much less relevant today. The danger with control on individual countries coming from the union is that it becomes a ‘them and us’ game. If it is in the national interest to free ride at the union’s expense, then activities such as fiddling the figures may also be seen as in the national interest, when clearly they are not. If austerity is imposed from above rather than from within, the political dangers to the Eurozone itself are obvious. It would, in my view, be much better for individual countries to take ownership of the control of their own national budgets. This could be done through a combination of national institutional reform and nationally determined fiscal rules. Calmfors and Wren-Lewis (2011) show how this combination is becoming increasingly popular. I do not think forcing countries to pass laws to follow balanced budgets really qualifies as taking national ownership!

Countercyclical fiscal policy in the Eurozone

In a previous post I looked at the evidence that there was a competitiveness crisis in the Eurozone as well as a debt crisis. I concluded that it is plausible that Germany is now too competitive (its real exchange rate is undervalued), and that other Eurozone countries may have to experience a period of stagnation to correct this.

If this is true, an obvious question is how this happened. One simple story is that the formation of the Euro reduced real interest rates in a number of countries, which provided a large stimulus to demand, and also helped generate housing bubbles in some countries. A related story is the rapid expansion in cross border lending by Eurozone banks documented by Hyun Song Shin. However here I want to focus on another question: how could this have been prevented?

                Standard macro has a simple answer: fiscal policy. The Eurozone outside Germany should have been running a much more contractionary fiscal policy in the years after its formation. If countries had done this, then a by-product would have been lower levels of debt when the global recession hit, which might have reduced the extent of the current debt crisis. But the main point is that it would have diminished the current undervaluation of Germany within the Eurozone, and so reduced the pain that countries outside Germany may now have to go through on that account.

                The really interesting question for me is why Eurozone countries did not pursue more contractionary fiscal policies. The evidence that inflation outside Germany was significantly higher than German inflation was clear enough. Here is consumer price inflation in Ireland, Spain and Germany, for example. We can see in 2009 the process of correction beginning, but as my earlier post showed, the correction process for the Eurozone as a whole has only just begun.

                In one sense the answer to my question is obvious. Contractionary fiscal policy involves higher taxes or lower government spending, and governments do not like doing this. However two other factors may have made things worse in this case.

1) In the run-up to the formation of the Eurozone, critics of the whole project focused on the costs of losing an independent monetary policy. Studies showed that an active countercyclical fiscal policy could reduce this, but significant costs remained. (Some of my own work in this area is discussed on my webpage.) One response from those arguing the case for the Euro was to deny the problem. If you deny a problem, you do not prepare for it.

2) When the Euro was formed, the focus was on the problem of debt, rather than the problem of avoiding persistent differences in national inflation. This led to the Stability and Growth Pact, with its famous 3% deficit limit. As many have noted, debt to GDP ratios in Ireland and Spain were falling from 2000 to 2007, while debt to GDP in Germany was rising. So for governments in Ireland and Spain, there was no great pressure from outside to run a more contractionary policy. In these circumstances, what chance would economists have in persuading them otherwise?  (Some did try: for example Lane, P. (1998), ‘Irish fiscal policy under EMU’, Irish Banking Review, Winter.) 

Gross Debt to GDP (Source: OECD Economic Outlook)

Why does all this matter? As everyone knows, the Eurozone is currently revamping how individual countries run their aggregate fiscal policy. With so much focus on the problem of debt rather than the problem of competitiveness, there is a danger of repeating the mistakes that were made when the Euro was formed, and ignoring the need for countercyclical fiscal policy.

One alternative is to in effect hardwire countercyclical fiscal policy by creating a fiscal union, where residents in countries that are growing too fast pay taxes to those growing too slowly. But as Kevin O’Rourke pointed out, proposals at the recent summit do not involve such a fiscal union, whatever they may be called in public. It is quite likely that such a union would be politically impossible at present. If that is the case, then using fiscal policy in a countercyclical way is essential if the Eurozone is to avoid recurring crises.