Sun, Jan 22, 2012 - Page 9 News List

How to create a depression

Failure to distinguish between cyclical and structural deficits means EU leaders might adopt new rules that force them into a depression

By Martin Feldstein

Negotiators are now working out the details ahead of another meeting of EU government leaders at the end of this month that 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 percent of GDP — an important tool for offsetting declines in demand: And it is unclear whether the penalties for total deficits that exceed 3 percent 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 percent 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 percent 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 percent of GDP. However, 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.

Martin Feldstein, professor of Economics at Harvard University, was chairman of former US president Ronald Reagan’s Council of Economic Advisers and is former president of the National Bureau for Economic Research.

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