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Intereconomics, January/February 2009 4
Preventing Recession in Europe:
National vs. European Approaches
Policymakers in the EU member states are currently shaping rescue packages to prevent
the financial crisis hitting their economies with unmitigated force. Each government is
responding to the emerging problems with a country-specific set of measures. Given
the global nature of the crisis, would coordinated action at the European level not be a
better approach? Was the German government – much-criticised for its initial reluctance
to adopt massive fiscal stimulation measures – right after all to exploit the option value of
waiting in a situation of high uncertainty?
A
lmost all European economies have fallen into
their worst recession in many decades. We ex-
pect a decline in GDP in 2009 of close to 3% for most
major members of the European Union.
1
Fiscal policy
has to respond forcefully. Even more so, Europe needs
a common fiscal boost. After all, the economies are
more closely linked to each other than ever before. On
their own, individual countries would not do enough
because too much of a national stimulus would spill
over to free-riding neighbours. Worse, the stimulus in
one country may come at the expense of its neigh-
bours if the programme is designed badly.
Yes, the case for a strong common European fis-
cal boost is easy to make, at least in theory. But as so
often in life, we need to take a closer look, not least
because the amounts of money thrown around in the
discussion are staggering.
Two Reasons for a Fiscal Stimulus?
In normal cyclical downturns, an activist fiscal pol-
icy with a major increase in government spending or
counter-cyclical tax cuts is usually not necessary. By
lowering the cost of credit for the economy as a whole,
central banks can deal with unwarranted shortfalls in
demand for goods and services better, faster and with
fewer long-term costs than parliaments and govern-
ments can with their laborious decisions on how much
to tax and spend.
Of course, the world is not facing a standard down-
turn this time. After the fall of Lehman Brothers and
Washington Mutual in mid-September 2009, the glo-
Holger Schmieding*
The Case Against a Common Fiscal Boost in Europe
* Chief Economist Europe, Bank of America, London, UK.
bal economy suffered the monetary equivalent of a
heart attack. Governments and central banks reacted
with unprecedented measures, providing safety nets
for their financial systems, cutting interest rates and
using intensive microsurgery to unblock the clogged
arteries of money and credit markets.
1
But these measures have not restored a healthy
flow of credit to households and businesses yet. Low-
er interest rates from the central bank can stabilise
household spending, stimulate business investment
and ease debt service burdens only if the stimulus
can pass freely through the financial system. While the
system itself is in intensive care, as it still was in Janu-
ary 2009, it cannot. As a result, central bank rate cuts
will probably affect the real economy only later and at
first more hesitantly than usual. This is the first reason
to consider a fiscal stimulus to bridge the time gap un-
til the monetary policy response has fully arrived.
Secondly, scared savers around the world rushed
into the safest of safe havens in late 2008, putting their
faith into the currencies and the government bonds
of the leading Western countries while shying away
from once-standard financial investments that are now
perceived as more risky. As a result, yields for 10-year
German government bonds (“Bunds”) fell to 2.8% in
January 2009, their lowest level on record. Although
the yield spreads between the German benchmark
and the comparable bonds from some peripheral EU
countries such as Ireland, Spain and Greece widened
substantially to their highest level since these coun-
1
Cf. Holger Schmi edi ng: European Themes 2009: Not Quite a
Lost Year, Bank of America, Economic Brief, 5 January 2009.
DOI: 10.1007/s10272-009-0273-3
Intereconomics, January/February 2009
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5
tries had qualified to join Economic and Monetary Un-
ion, even these countries can still finance themselves
at much lower nominal yields than usual.
Acting through their governments, taxpayers in the
Western world can thus collectively borrow at unusu-
ally attractive rates while, individually, they face unu-
sually tough credit constraints. During such a period
of tight credit conditions for the private economy, it
can thus pay to outsource some of the consump-
tion smoothing, that is the temporary borrowing in a
downturn, from the individual to the collective level. By
running higher deficits and augmenting aggregate de-
mand, governments can satisfy the increased demand
for government bonds and raise consumption more
cheaply than households could if they were to borrow
themselves. This is the second argument in favour of a
fiscal stimulus in the current situation.
Three Criteria to Judge a Fiscal Stimulus
Higher public deficits shift the tax burden onto fu-
ture generations. To justify this, a fiscal injection has to
meet three criteria:
it has to be fast to actually help while the economy •
needs it most;
it has to improve the long-term growth potential so •
that future gains in tax revenues make it easier to re-
duce the public debt again afterwards;
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Intereconomics, January/February 2009 6
it should minimise the risk that it gets hijacked by •
special interest groups.
A key issue is whether a joint European Union fis-
cal programme has a better chance to meet these cri-
teria than a motley collection of independent national
measures. In this respect, a comparison between the
centralised US response and the largely decentralised
European response to the immediate banking crisis in
late September and October 2008 is quite revealing.
Financial Bailout Programmes:
A Revealing Example
The USA seemed to have all the advantages: one
central administration staffed with financial market ex-
perts at the highest level who could rely on well-estab-
lished procedures of cooperation between the Treasury
(finance ministry), the central bank, the financial regu-
lators and the two chambers of parliament. The USA
thus could act fast and forcefully. And it did when the
Administration realised the extent of the problem.
The US Administration proposed a massive pro-
gramme to take bad assets off the balance sheets of
banks (troubled assets relief programme, TARP) on 19
September 2008. Despite full support from President
Bush, the two contenders for his succession, the cen-
tral bank, the regulators and countless financial market
experts, the programme foundered in a first vote in the
US Senate on 29 September. The result sent financial
markets into a tailspin. Shortly thereafter, both houses
of parliament passed a modified version.
But what happened then? Initially, hardly anything.
As it turned out, the TARP had a central design flaw.
There simply was no way to find a general mechanism
to determine the price at which troubled assets, which
had become untradable, could be taken off the books
of banks. Over time, the US Administration changed
the nature of the $700 billion TARP programme com-
pletely, using the money to inject capital into banks
and to guarantee banks against losses instead. The U-
turn became obvious by 14 October. When even this
did not seem to help enough, the USA finally changed
tack again, returning to the idea of shifting the risk of
troubled assets from banks to the government for a
fee. In the end, it was the Swiss example – that is the
tailormade rescue package of the Swiss National Bank
for UBS – which provided the blueprint for how the US
authorities finally ended up dealing with the problems
of major banks on a case-by-case basis.
Now look at the messy ways of crisis control in the
European Union. First, Ireland shocked its neighbours
by doing what Sweden had successfully done in late
1992 to prevent a ruinous run on its banks: it guaran-
teed all bank deposits on 30 September 2008. The
resulting flow of deposits from British banks into Irish
banks infuriated the UK authorities and forced them to
accelerate their own crisis response. Other countries
also started to seriously discuss national bank bailout
plans, sometimes openly, sometimes behind closed
doors.
A first Paris summit failed spectacularly to agree on
a common European position on 4 October 2008, ex-
cept for the unspecific promise to let no major bank
fail in Europe and de facto suspension of the fiscal
deficit limits enshrined in the European Stability and
Growth Pact. Right after her return from Paris, German
chancellor Merkel – apparently on new information
about the problems of some German banks – assured
all Germans that their deposits were safe, de facto
promising a blanket deposit guarantee. Like the Irish
coup, this unilateral move raised eyebrows across Eu-
rope. But it also forced other European governments
to look even harder at the issue. Britain then came up
with a comparatively sensible anti-crisis programme
on 8 October, including enhanced deposit guaran-
tees, an offer to recapitalise banks with public money
and to guarantee bank funding for three years. Other
European countries endorsed the main principles of
it at a Eurozone summit meeting in Paris the Sunday
thereafter, 12 October 2008. Within three days, most
West European countries then came up with national
bailout programmes based to a significant degree on
the British example while taking national peculiarities
into account.
The political process in Europe certainly was not
pretty. But it did still show Europe at its best. Instead
of trying to devise one joint approach from the very
beginning, Europe used its diversity and its internal di-
visions to its advantage. Being forced to react to each
others’ unilateral moves, learning from one another by
seeing close-up what seems to work – or not work –
in one country, the European Union ended up within
a few weeks with a set of largely compatible national
bank bailout programmes. Competition, imitation and
an institutional setting which reduces the risk of solv-
ing national problems too much and too openly at the
expense of one’s neighbours due to the frequent inter-
action of the various national leaders on a wide variety
of issues (repeated games) are the hallmarks of the
European approach. The messy European way deliv-
ered better results, with much less subsequent need
to correct design flaws afterwards, than the central-
ised “grand-design” US approach.
This carries a lesson for fiscal policy: in theory, na-
tional stimulus programmes may be suboptimal be-
cause they may not take trade and finance linkages
Intereconomics, January/February 2009
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7
within the European Union fully into account. But the
chance to learn from one another reduces the risk that
a flawed grand design could be adopted. The prob-
ability that, with a central design, Europe could simple
get it wrong, is far too great. We need not even get
into the history of the Common Agricultural Policy to
find further examples to make this lesson. National ac-
tions with some minimum coordination, and respect
for some basic common rules, are less risky.
The Forbidding Politics of a Common
European Boost
Now turn to the genuine politics of a joint European
fiscal response. Imagine that a committee of experts
had indeed been able to design a grand European fis-
cal programme which, if fully implemented, would yield
better results than individual national programmes.
However, decisions on how much to tax and spend are
the prime prerogative of national parliaments. Whether
or not a European parliament may eventually take over
this responsibility in a few generations’ time is a mute
question for the time being.
A European stimulus programme would thus have
to be passed by the parliaments of all major mem-
ber states. That is a tall order indeed. How would, for
instance, Berlin react if, say, Britain rejected a pro-
gramme that is designed to work only if all key players
take part? Would Germany still play ball, knowing that
it would not get its quid-pro-quo from the other side
of the English Channel. The fate of the Lisbon Treaty
does not make us very confident that a pan-European
fiscal approach could make it through the national ap-
proval processes intact and in time.
This already points to a further obvious drawback of
a joint European fiscal response: adding a European
layer of preparation and decision making would likely
retard the overall process, wasting a commodity that
– in the fiscal crisis response – is even scarcer than
money, namely time.
In short, a common European fiscal response to
the crisis would most likely be more flawed in its de-
sign and even more belated than national fiscal pro-
grammes tend to be anyway. A joint European fiscal
programme is thus simply a bad idea. If the pursuit of
it distracts attention from what needs to be done in
other fields of policy, or what governments could sen-
sibly do at home, it might do harm rather than good,
even abstracting from the costs that an ill-designed
European initiative would place on taxpayers of the fu-
ture.
Of course, the European institutions could and
should still play a role. The most noble function of
Brussels is to be the guardian of the Treaties. As such,
the EU institutions should fulfil their normal task of
enforcing some common non-discrimination rules.
For instance, no national fiscal stimulus should have
a payout only for buying a domestic car. And support
for financial institutions should not distort competition
on financial markets by too much and for too long. But
beyond that, European institutions should leave the
fiscal response to the severe recession – or the ab-
sence of such a response – to the member states.
National Fiscal Programmes
This brings us back to the question which kind of
fiscal response could make sense. National circum-
stances differ. We focus our discussion mostly on the
situation in and experiences of some of the bigger and
long-standing EU members, not on those of the small-
er EU newcomers.
As discussed before, the theoretical case for a fiscal
stimulus is stronger than usual due to the extraordi-
nary nature of the current downturn in which the trans-
mission mechanism of monetary policy is impaired
and the private sector faces unusually tough credit
constraints.
Public Investment Programmes
In theory, public investment programmes could
make most sense. Standard Keynesianism as taught
in the textbooks of the 1970s and 1980s (the forma-
tive years of most decision makers today), explains
that public spending on domestic projects minimises
the “leakages” into savings and imports. The multiplier
effect is thus big, delivering a boost to demand well
beyond the extra fiscal expenditure.
Unfortunately, the practical experience with such
crude Keynesian experiments across the world is dis-
mal. Precious time is usually wasted in devising the
programmes. In addition, the process often falls prey
to special interest groups in the lengthy parliamentary
deliberations about spending priorities. The process
can result in the proverbial “bridges to nowhere” which
help no one at all except, briefly, those who get paid
for building them. In the 1970s for instance, German
cities used generous grants of such federal investment
programmes to build splashy new swimming pools,
only to close many of them again a little later when
they could not afford to pay the lifeguards and other
running costs out of their own city pockets.
Against the better judgement of many German of-
ficials, Germany had twice granted its neighbours and
friends their wish to add to global demand by a German
stimulus at home. Both the locomotive experiment of
the late 1970s and the much smaller “echo easing” of
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Intereconomics, January/February 2009 8
the late 1980s ended in tears. In both cases, much of
the additional earmarked resources were spent when
the economy was already recovering from the worst
of the downturn which had triggered international calls
for a German fiscal boost.
2
The stimulus thus ended up
being more pro-cyclical than anti-cyclical. Incidentally,
this pro-cyclical element then elicited a harsh Bundes-
bank response which helped to prepare the ground for
the next cyclical downturn.
Tax Cuts: Yes, But
Tax cuts can be passed quickly, leaving special
interest groups less time to interfere. A temporary in-
come tax cut, for instance in the form of tax rebate
checks, can help to bridge the time gap until the mon-
etary stimulus starts to work. The best tax cuts could
also enhance the long-term incentives to work and in-
vest.
However, whether or not tax cuts will actually work
depends very much on the nature of the cuts and on
national circumstances. Again, take the case of Ger-
many. The country has fallen into a deep recession be-
cause demand for its highly cyclical exports of flashy
cars and quality machinery has collapsed, triggering
a major retrenchment in investment in export-oriented
industry. In theory, raising consumption through tax
cuts could be an obvious remedy. However, German
consumers do not lack the money to spend. Helped
by still-rising employment and less subdued wage
gains, German disposable incomes were up 3.1% year
on year on the third quarter of 2008. The point is that
Germans are not spending the money they have, rais-
ing their savings rate from 10.7% of their disposable
income in the autumn of 2007 to 11.4% in the third
quarter of 2008 instead. If Germany had followed Brit-
ain (temporary VAT cut until the end of 2009 while an-
nouncing at the same time that taxes would have to go
up significantly in the years thereafter), many Germans
may simply have saved the extra money to provide for
future tax increases (Ricardian equivalence).
Incidentally, even in Britain, the major impact of the
VAT hike could be to distort the pattern of consump-
tion at the turn of the year 2009/2010. Judging by the
German experience with the VAT hike of 2007, many
Britons will probably go on a spending spree for du-
rable consumer goods in late 2009 and make up for it
by not buying such goods after the return to the higher
VAT rate at the start of 2010. Apart from this volatility,
the overall effect on consumption could remain small.
And the rush to buy in late 2009 is unlikely to trigger
any business investment response.
2
For details see Herbert Gi er s ch, Karl-Heinz Paque, Holger
Schmi edi ng: The Fading Miracle – Four Decades of Market Econo-
my in Germany, Cambridge University Press 1992, chapter 5A.
The case for tax cuts is strongest if such cuts en-
hance the incentive structure of the economy and thus
raise the trend rate of growth. Even under Ricardian
equivalence, such a tax reform would stimulate con-
sumption as households adjust to improved long-term
income expectations. Unfortunately, those changes
which, according to standard Keynesian logic, are
most likely to work because they enhance the spend-
ing power of low-saving households (tax rebate
checks, enhanced welfare benefits and income tax
cuts focussed on low-income households) are often
the ones with no positive impact on incentives at all,
and likely some negative impact on the incentives to
work instead.
Of course, there are tax cuts which could both de-
liver an effective fiscal boost and be considered “fair”.
Our favourite example are the payroll taxes in Ger-
many and France, which are split in equal measure
between employers and employees. As the taxes are
capped at a certain level, a cut in these taxes would
benefit high-income households proportionally less
than a general reduction in income tax rates would.
Slashing the payroll taxes aggressively would enhance
the purchasing power of working consumers. It would
also cut labour costs for employers. In the short-term,
this would enable them to keep a few more workers
on their payrolls throughout the recession, a good way
to mitigate at least a little the mounting fears of unem-
ployment which are likely to weigh on consumption.
More importantly, it would encourage employers to
make more use of labour, a factor of production that
is still underemployed in most European countries
with their comparatively high rates of unemployment.
By encouraging a better use of resources on trend,
a determined cut in such taxes would thus raise the
supply potential and income expectations in the econ-
omy. Cutting payroll taxes could thus beat the simple
Ricardian equivalence.
Our verdict on tax cuts to combat the recession is
thus ambiguous. Tax cuts can be implemented much
faster and have a chance to work better than simply
raising government spending. Well-designed tax cuts,
such as reductions in payroll taxes, would be the best
way to do so. Such tax cuts would be worth the long-
term fiscal cost, especially as an enhanced growth and
employment potential would eventually reduce the fis-
cal costs. Other tax cuts, such as a temporary reduc-
tion in the VAT, may not be worth the long-term costs.
The German Example
On 12 January, German coalition leaders sealed
a deal on a €50 billion fiscal stimulus programme for
2009 and 2010. The key elements are extra infrastruc-
ture spending (€18 billion for the two years taken to-
Intereconomics, January/February 2009
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9
gether), cuts in income and payroll taxes (around €18
billion for the two years) and a number of smaller
measures such as an increase in child allowance
and a €2500 lump sum for replacing an old car with
a new one.
This second German stimulus package is a very
mixed batch, in our view. To judge it, we need to ask
two questions: (1) does it stimulate demand to damp-
en the recession, and (2) does is affect the long-term
growth potential of the economy (supply)?
The cuts in income and payroll taxes will kick in
only on 1 July. Given Germany‘s cumbersome plan-
ning and disbursement procedures, we also expect
the bulk of the extra government spending to be
used only in late 2009 and in 2010. As a result, the
actual stimulus in the first half of 2009 will probably
be negligible. However, to stop and reverse the cur-
rent downward spiral in investment and business
early, an immediate stimulus to demand would have
made most sense, for instance a big immediate cut
in payroll taxes. As a rough guess, the total fiscal
stimulus from this package that will be effective in
2009 will probably not surpass €12 billion with the
impact backloaded rather than frontloaded.
However, we have to add the first stimulus pro-
gramme passed in December, a hotchpotch of meas-
ures including an accelerated depreciation allowance
for business investment, a bigger tax break for home
repairs and the like. This first package could provide
up to €8 billion in fresh money for 2009, in our view.
In addition, the Constitutional Court has re-instated
a tax break for commuters. Including the re-imburse-
ment of overpaid tax to commuters, this could put
€7.5 billion into the hands of commuters this year.
Germany‘s total fiscal stimulus for 2009 could thus
add up to around €30 billion, equivalent to 1.2% of
GDP, followed by roughly €35 billion for 2010. If the
economy recovers in 2010, the tail end of the stimu-
lus could end up being partly pro-cyclical rather than
counter-cyclical.
The German programme highlights the risks that
a fiscal stimulus could come too late to actually
smooth the cycle much. As there is hardly any stimu-
lus for the most crucial time period, the first half of
2009, the fiscal boost may not kick in before mon-
etary policy is also starting to work. Germany at least
has not managed to use fiscal policy to fill the gap
which the temporary impairment of monetary policy
has created.
For the long-term growth prospects, the package
is also a very mixed batch:
The one element that is clearly positive, the cut in •
payroll taxes, is also one of the smaller elements,
probably with €3 billion for the second half of 2009
and €6 billion for 2010.
The additional cut in income taxes is also welcome. •
But its structure (a cut in the starting rate of income
tax from 15% to 14% and minor changes to the tax
schedule) will not do very much to strengthen the
incentive to work.
Our experience with additional German public •
spending to combat recessions is that most of the
money does little to enhance the long-term growth
prospects of the country even if the spending
comes under the label “investment”. For instance,
Germany very much needs a better school system.
But repairing some old school buildings faster than
initially planned will do little to raise the quality of
education.
Against that, we have to set the long-term costs
of higher public debt. We expect Germany to clearly
breach the Maastricht 3% deficit limit in 2009, prob-
ably with a result around 4%. The deficit may not
shrink very much in 2010. The resulting extra bur-
dens on future generations could more than offset
the very small positive impact on incentives and thus
on long-term growth which some of the measures
agreed upon may have.
Summary
The case for some fiscal stimulus in the European
Union is stronger in the current downturn than usual.
However, the case is still not very convincing. A joint
European approach would likely be counterproduc-
tive. A series of national initiatives, subject to some
EU safeguards against flagrant “beggar-thy-neigh-
bour” attempts, at least gives countries the chance
to learn from each other. National approaches could
make more sense. However, the example of the big-
gest EU member state, Germany, does not inspire
much confidence that the national fiscal programmes
could be designed well enough to warrant their long-
term fiscal costs. The verdict on such national pro-
grammes has to be taken on a case-by-case basis.
All in all, the most important task for European au-
thorities is to get the monetary stimulus right, and
especially to repair the transmission mechanism of
monetary policy through the banking system and fi-
nancial markets so that the unusually low rates and
the very generous injections of central bank liquidity
could work.
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Intereconomics, January/February 2009 10
T
he current crisis has led to an almost instantane-
ous convergence on the view that fiscal policy
needs to be used vigorously to mitigate the impact of
the financial crisis on the real economy. This conver-
gence of view is global. Governments on all continents
have recently announced large stabilisation packages,
with little opposition from economic experts. There are
serious arguments for this sudden conversion to the
view that the government must intervene to sustain
demand: official (central bank) interest rates are rapid-
ly nearing zero almost everywhere, implying that mon-
etary policy might have become ineffective. Moreover,
with interest rates apparently at historically low levels
on most maturities most models indicate that fiscal
policy should be particularly effective in stimulating
demand since under the present circumstances higher
deficits apparently no longer crowd out investment or
other expenditure through higher interest rates.
This sudden preference for an active fiscal policy is
thus usually motivated by the need of the present ex-
ceptional circumstances. However, a closer look at the
data suggests that there have been some important
shifts in public finance that started well before the fi-
nancial crisis became the dominant theme. Moreover,
it might well be that it will be more difficult than cur-
rently anticipated to reduce government expenditure
once the crisis is over. The share of the government
in the economy might thus increase on a longer term
basis.
Anglo-Saxon public finance used to reflect the Rea-
gan/Thatcher legacy of small government and low tax-
ation. However, the difference between Anglo-Saxon
and (continental) European public finance has been
changing gradually over the last decade as expendi-
ture has trended upwards in the USA and the UK,
whereas it has been under control in most of continen-
tal Europe. In this sense there has been convergence.
The convergence in expenditure patterns will actually
accelerate as the result of a shorter term divergence
which concerns the response of fiscal policy to the fi-
nancial crisis: fiscal deficits are increasing much more
in the Anglo-Saxon world than on the continent. The
key reason for this latter difference might lie in the dif-
ferent financial situation of Anglo-Saxon households.
The remainder addresses these three issues in turn.
Convergence of Expenditure Ratios
A key indicator of the present and future tax pres-
sure is the ratio of total public expenditure to GDP
because all expenditure has sooner or later to be fi-
nanced by taxation. On this account the USA and the
UK started ten years ago with a strong advantage as
their expenditure ratios were below 40% of GDP, com-
pared to close to 50% in the euro area (and Germany),
giving the UK an advantage of more than 8 percent-
age points and the USA one of close to 14% of GDP.
This advantage has been completely lost in the case
of the UK (in whose case one can use the 2009 projec-
tions from the Commission as the fiscal response to
the financial crisis has been more on the revenue side
(e.g. VAT reduction in the UK)) and has been almost
entirely lost in the case of the USA. In the UK gener-
al government expenditure is now at 47.2% of GDP,
slightly higher than on average in the euro area. This
implies that the UK has de facto to become a high tax
country. The deterioration is even more pronounced
relative to Germany which over recent years has de-
cisively cut back on public expenditure, from slightly
above the euro area value to around 44% of GDP to-
day, about 4 percentage points below the UK value. In
this sense Germany has positioned itself as a future
low tax country within Europe (at least until the most
recent stimulus package was decided).
For the USA it is more difficult to get precise num-
bers, but the intention of the Obama administration
seems to be to increase public expenditure massively.
It is thus likely that the USA will soon have a govern-
ment that has about the same economic role in the
economy as in Germany. Sooner or later taxes will
thus have to increase to the German level.
Moreover, the share of the government in GDP also
indicates roughly the importance of the automatic sta-
bilisers. With this convergence in expenditure patterns
automatic stabilisers have also become roughly simi-
lar on both sides of the Atlantic.
Table 1 illustrates these trends allowing for a com-
parison of present expenditure patterns with those of
about ten years ago (around the start of EMU). As the
fiscal plans are constantly changing, the numbers for
Daniel Gros*
Convergence and Divergence in Public Finance
* Director, Centre for European Policy Studies (CEPS), Brussels, Bel-
gium.
Intereconomics, January/February 2009
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11
2009/10 can be only rough estimates based on the
published stimulus packages in different countries.
Divergence (in the Fiscal Policy
Response to the Crisis)
The deterioration in Anglo-Saxon finances is im-
mediately apparent from the numbers for the deficits.
Here again the deterioration set in well before the cur-
rent crisis: over the 5-year cycle 1997-01 the UK and
the USA had a deficit about one full percentage point
below that of the euro area. In 2007, thus even before
the financial crisis hit the UK and the US economies
particularly hard, this had already changed completely
with both Anglo-Saxon countries running a deficit just
below 3% of GDP, two percentage points above the
euro area value. Compared to the euro area the de-
terioration was thus equal to three percentage points
of GDP – over a period during which the Anglo-Saxon
economies were widely assumed to be performing
much better, supposedly because of their more inno-
vative financial markets.
Given the large fiscal stimulus packages, again in
both Anglo-Saxon countries (already decided in the
UK, still to be formalised in the USA) this trend is set to
continue over the next years. For 2009 the Anglo-Sax-
on deficits are now projected at around 9% of GDP
and 2010 is anybody‘s guess.
1
By contrast, the deficit
for the euro area can be expected to be closer to 4%
of GDP, a gap of five percentage points.
As an aside one might note that this implies that
deficits of this magnitude are clearly not sustainable.
At some point in the not so distant future the UK and
the USA will thus have to undertake a massive fiscal
retrenchement. This will be a challenge from both the
economic and political point of view as growth is like-
ly to remain weak under the combined influence of a
weak housing and financial sector.
What is the reason for this striking difference in the
response of fiscal policy to the looming recession?
1
Currently it is expected that the deficit will increase even further in
both the UK and the USA.
Most predictions for 2009 imply currently that the
loss of growth should be fairly uniform across Europe,
mostly in the 4-5% range as growth goes from about
2.5% to minus 2% almost everywhere. It is widely ex-
pected that the recession will actually be somewhat
shorter in the USA. Predicted growth rates for the USA
are somewhat higher for both 2009 and especially for
2010.
The key reason for the difference in the revealed
preference of governments in terms of the use of fis-
cal policy is probably very simple: there are important
differences in economic structures which make fiscal
policy much more effective under the current circum-
stances in Anglo-Saxon countries. To put it succinctly:
tax rebates and transfers can help the insolvent Anglo-
Saxon household to maintain consumption. But the
solvent German household is likely to add any addi-
tional income, which is known to be temporary, to its
already considerable savings.
Differences in the Financial Situation of
Households and the Effectiveness of Fiscal Policy
Many discussions about fiscal policy remain ab-
stract and national “stimulus” plans are usually report-
ed in terms of one headline figure, namely the increase
in the budget deficit that is expected from them. How-
ever, the effectiveness of a stimulus plan should not
be measured by the increase in the deficit, but the in-
crease in overall demand it provokes.
The most direct way for governments to increase
demand is to buy goods and services directly from
the market. However, it is not widely recognised that
it is difficult to obtain a large boost quickly in this way
since most European governments spend very little
this way. Table 3 documents this for the major expend-
iture items.
Governments spend about one fifth of GDP on con-
sumption of goods and services. However, this ex-
penditure category cannot provide a sustained boost
to the economy since one cannot stock these items
for future use. This leaves public sector investment as
Sour ces : Ameco; own estimates.
Table 1
Total General Government Expenditure
in % of GDP
(A) Average
1997/2001
(B)
2009/10
(C) Change
(B)-(A)
Germany 47.4 45 -2.4
Euro area 47.7 48 +0.3
UK 39.1 49 +9.9
France 52.5 55 +2.5
USA 34.8 42 +7.2
Table 2
Fiscal Deficit in % of GDP (General Government)
Sour ces: *Ameco; **Commission forecast of January 2009.
Average
1997/2001
2007 2009
expected
November*
2009
expected
early 2009**
Germany 1.6 0.2 0.2 2.9
Euro area 1.6 0.6 1.8 4.0
UK 0.6 3.8 5.6 8.8
France 2.1 2.7 3.5 5.4
USA 0.4 2.8 7.2 8-10
FORUM
Intereconomics, January/February 2009 12
the most often mentioned expenditure category, which
has the added advantage that higher public sector in-
vestment today should lead to higher productivity to-
morrow.
However, one has to keep in mind that public sector
investment represents only 2-2.5% of GDP and is diffi-
cult to increase quickly since the large projects, which
make up the bulk of the expenditure, take often a dec-
ade or more to realise. Even if governments were able
to increase public investment by 20% in one year this
would result in a fiscal impulse of less than 0.5% of
GDP. In the USA public sector investment is expected
to increase by about 40%, from 2.6 to 3.6% of GDP
(in 2009).
In reality fiscal policy must thus, if it wants to be
effective immediately, work through transfers to the
private sector, either via lower taxes or via higher
transfers to households. The key problem here is that
under the present circumstances of extreme uncer-
tainty households might just save any increase in their
disposable income. How likely is this to happen? A
key factor will be the financial position of households
themselves: households that depend on credit to fi-
nance their consumption will be most affected by the
credit crunch and are thus most likely to react to a tax
cut by maintaining their consumption. For this type of
household a tax cut (or an increase in expenditure) will
thus be an effective tool to prevent an even sharper
drop in consumption. However, for households which
do not depend on credit the situation is quite differ-
ent. Households that are saving anyway will probably
at present just increase their savings in response to an
increase in their disposable income which they know
to be temporary.
This implies that the effectiveness of fiscal policy will
vary greatly across the EU. Table 4 shows that in only
two of the larger member countries are households
on average net borrowers. Not surprisingly this is the
case in Spain and the UK. In these two countries (with
the largest housing bubbles) fiscal policy should thus
be effective. However, in the three other large mem-
ber countries households are on average net savers.
In these countries, and in particular in Germany where
households are net lenders to the tune of about 10%
of their disposable incomes, fiscal policy will not be
effective as households can just increase their lend-
ing in response to a tax cut. The experiences of the
USA and Japan point in a similar direction. In Japan
the government has been running very large deficits,
but an increase in private savings has completely off-
set this, leaving domestic demand flat for a decade.
Even in the USA, where the private savings rate has
been close to zero, households still choose to save a
large part of the tax rebate implemented in the early
summer of 2008.
Concluding Remarks
With the global economy in an unprecedented re-
cession it is natural that attention is focused on the
various fiscal stimulus packages enacted almost eve-
rywhere, in Europe, the USA and even China. This
contribution argues that there had already been some
convergence in the share of the government between
Anglo-Saxon and continental European countries even
before the increases in public sector expenditure pro-
grammed now. Germany in particular stood out until
recently as moving towards the lowest public expendi-
ture share in GDP, lower even than the “Anglo-Saxon”
average.
The strong financial situation of households in most
of continental Europe (and, again, particularly in Ger-
many) suggests that tax cuts and increases in trans-
fers will have only a rather limited impact on private
demand. The actual impact of the recently enacted
stimulus packages in Germany and elsewhere in Eu-
rope might thus be quite limited. By contrast, one
would expect that the over-indebted households in the
USA and UK will react much more to similar measures.
Fiscal policy should thus be much more effective in the
Anglo-Saxon world, which might be why this is also
where the call for a fiscal stimulus started and where
the deficits are now the highest.
Table 3
Expenditure of General Government as % of GDP
Final consumption Social transfers Investment
EU27 20.6 15.3 2.6
EU 15 20.8 15.4 2.5
Euro Area 16 20.3 16.0 2.6
United States 16.6 19.0 3.4
Germany 17.6 16.5 1.5
France 23.0 17.4 3.2
Italy 20.5 17.7 2.3
Spain 19.3 12.6 4.0
UK 21.4 10.0 2.0
Table 4
Net Lending of Households
Sour ce: Ameco.
Euro billion % of income
Germany + 144 9
Spain - 27 -5
France + 66 5
Italy + 63 5
UK - 97 -8
Intereconomics, January/February 2009
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13
A
s the financial crisis has mutated into a global re-
cession the attention of policymakers has shifted
from the financial sector to fiscal policy as a demand
tool. At the European level the Commission has called
for coordinated action to stimulate demand and most
member countries have by now enacted sizeable fis-
cal “stimulus” plans.
However, with this exclusive concentration on fis-
cal policy Europe is missing a great opportunity in the
current crisis. These times of “extraordinary politics”
should be used to carry out some of the badly needed
structural reforms that have kept down the perform-
ance of the European economy for so long. The reason
why many of these reforms have not been undertaken
is clear: most of them meet with fierce political opposi-
tion from the start although some also pay in terms of
public budgets, but only in the long-run.
Rather than spreading resources across a variety of
public expenditure programmes of dubious effective-
ness, rather than trying to cheat with the numbers of
stimulus packages that will always fail to be as size-
able as the current global recession would require,
governments should concentrate their efforts on de-
vising long-ranging reforms and buying consensus
around them. This means increasing public deficits in
the short run while enhancing the long run structural
performance of their economies and improving their
position along the intertemporal public budget con-
straint. Economic research on the political economy
of reforms and, above all, the experience accumulated
over decades of reforms can be very helpful in find-
ing ways to compensate the short-term losers of these
reforms. More spending today should aim at making
politically feasible what without compensation and in
ordinary times is not.
This effort does not require as much policy co-or-
dination as the fiscal stimulus packages proposed by
the G20, the IMF and other multilateral organisations to
counter the global recession. Structural reforms have
indeed a national dimension, they vary from country to
country and their opponents also differ across nations.
Structural reforms are mainly a matter of national gov-
ernments and constituencies. Yet by pursuing these
reform efforts simultaneously, governments would be
able to strengthen their positions vis-à-vis national vot-
ers and exploit yardstick competition, drawing on the
example of the other countries. Experience has shown
that European public opinions often react to events oc-
curring in other countries. We had numerous examples
of political spillovers in the recent history of the Union,
from fiscal discipline and social pacts associated with
the convergence to euro, to the tightening of migration
policies, to the increasing popularity of flexicurity ar-
rangements. Sometimes these spillovers have worked
in undesirable directions (as in the case of migration
policies after the enlargement). Now it is time to have
them playing in favour of long-term growth.
European institutional “rigidities” – those barriers
that keep markets from operating effectively – ex-
ist because, somewhere, there is a group benefiting
from them and lobbying for their preservation. What is
more, such barriers rarely operate in isolation; a regu-
lation in one area calls for regulations in another area.
That is why the countries with the most restrictive la-
bour markets usually have the most tightly regulated
product markets.
Removing these rigidities is proving extremely diffi-
cult, and not because governments do not wish to car-
ry out reforms. The fact of the matter is that measures
such as these usually encounter strong political op-
position; they are initially unpopular while they pay in
the long run. Governments with short horizons do not
want to pay the political costs of these reforms; they
are concerned that, by carrying them out, they may
not be re-elected. As stated by the European veteran,
Jean Claude Juncker, “They know what to do, but do
not know how to be re-elected afterwards”. However,
the current recession is creating a TINA type situa-
tion: There Is No Alternative to carrying out reforms.
Governments will not be blamed for the unavoidable
recession, but for the way in which they prepared their
countries for the aftermath of the crisis.
A key element in many reforms concerns the labour
market and associated social legislation. Rigidities
in these areas are widely perceived to be the key to
improving the economic performance of Europe. The
Fondazione Rodolfo Debenedetti has now established
an inventory of labour market and social policy re-
forms carried out in EU member countries during the
1986-2006 period. Reforms are categorised as either
popular or unpopular, marginal or radical. This analysis
revealed that – contrary to common wisdom – many
Tito Boeri*
Seizing the European Day
* Bocconi University and Fondazione Rodolfo Debenedetti, Milan,
Italy.
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Intereconomics, January/February 2009 14
reforms have, in fact, been carried out over the past
two decades. We counted almost 650 reforms, that is,
about 2.2 per year and country. However the changes
have often been marginal: 583 out 645 reforms, that is
roughly 90 per cent of the regulatory changes were not
structural reforms. This means that these regulatory
changes were not comprehensive reforms, address-
ing the broader design of existing systems rather than
their minor features.
In particular, a structural reform of the employment
protection legislation is one that does affect all types
of contracts (e.g. it should also concern workers under
permanent contracts and not only those with fixed-
term contracts). A reform of non-employment benefits
is structural insofar as it affects the entire population
at risk, that is, the population of working age. Finally,
a reform of the public pension system is structural if it
is going to affect, sooner or later, all future cohorts of
pensioners.
Moreover, reforms can be split between those that
are unpopular, as they reduce the generosity of public
pensions or non-employment benefits or make em-
ployment protection less strict (445 out of 645, that
is, about 70 per cent) and those moving in the oppo-
site direction. We find frequently reforms undoing one
another over a few years. These inconsistencies and
the marginal nature of most reforms have significantly
increased the complexity of the European institutional
landscape.
In the field of employment protection, for instance,
we have assisted a multiplication of contractual types,
with a number of fixed-term and unstable jobs going
hand in hand with permanent and still heavily protect-
ed positions. Pension rules are getting different from
cohort to cohort. And there is a huge number of dif-
ferent soft landing schemes to retirement. All this has
increased the dualism of European labour markets,
making them more segmented not only between in-
siders and outsiders but also among various types of
outsiders. This overrepresentation of marginal reforms
among the unpopular regulatory changes is a clear
indication of the fierce political opposition that these
reforms face.
Thus, the message has so far been mixed: many re-
forms have been undertaken, but few resulted in last-
ing structural improvement. Can Europe do better now
that a deep recession is unavoidable? An important
message of this inventory (see also Table 1) is that dur-
ing recessions or at times of economic stagnation it is
actually easier to carry out these “politically difficult”
reforms than proceeding the other way round. In par-
ticular, when GDP was growing at more than 2 per cent
per year, there were 272 politically difficult reforms, but
also 148 reforms doing the popular job of increasing
generosity, adding more employment protection and
reducing rewards from participation. There is a higher
probability of carrying out the key reforms, those that
are politically difficult and structural, during downturns
than during upturns. And these reforms are more likely
under a recession (19 per cent of country-year obser-
vations) than during periods of strong growth (16 per
cent).
Thus, the view that negative or slow growth pre-
vents difficult reforms does not find support from this
Table 1
Labour and Social Policy Reforms and the Macroeconomic Environment
(1986-2006, EU15 less Luxembourg)
Politically Difficult Reforms Politically Popular Reforms
GDP growth GDP growth
Downturns Upturns Downturns Upturns
of which
recessions
of which
strong growth
of which
recessions
of which
strong growth
Employment Protection
Legislation
marginal 6 2 43 25 6 1 54 47
structural 2 2 10 8 2 2 7 6
Non-Employment
Benefits
marginal 26 8 221 160 6 1 53 45
structural 5 1 15 11 1 3 1
Public Pensions marginal 16 5 85 57 9 5 58 48
structural 3 1 13 11 1 1
Total per column 58 19 387 272 24 9 176 148
Of which structural (%) 17% 21% 10% 11% 13% 22% 6% 5%
Number of country-years 26 21 247 187 26 21 247 187
Reforms per country-years 2.23 0.90 1.57 1.45 0.92 0.43 0.71 0.79
Structural reforms per country-years 0.38 0.19 0.15 0.16 0.12 0.10 0.04 0.04
Not es : GDP growth: downturns imply g<1, Upturns g>1, strong growth g≥2. In brackets, average number of reforms per year and country (Ex:
19 politically difficult reforms in periods of recession / 21 country-years of recession).
Intereconomics, January/February 2009
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15
I
t is clear by now that the financial crisis has become
a crisis of the real economy, not only in the USA and
the UK, but especially in euro area member countries
like Ireland and Germany. According to the most recent
interim report by the EU Commission, GDP in the EU is
expected to fall by 1.8 per cent in 2009 before recov-
ering moderately by 0.5 per cent in 2010. This is the
consequence of a severe contraction of world trade
and manufacturing output and, in some countries, of
overdue corrections in housing markets.
1

Policymakers in the EU member states are currently
shaping rescue packages to mitigate the impact of the
crisis on their economies. Even Germany has acted,
with the German coalition government recently agree-
ing on a substantial stimulus package, after an evening
of heavy-handed negotiations.
2

We shall first discuss whether fiscal policy is the ge-
neric solution to sustain demand in the current crisis
and highlight the potential benefits of fiscal policy co-
operation in the euro area. Following that, we check
whether the option value of waiting in times of uncer-
tainty is a good guideline for macro policies in times of
crisis.
Fiscal Policy as the Generic Solution to Sustain
Demand?
Taking the dire outlook as a starting-point, politi-
cians and economists are pondering about what could
be done to keep the real economy from collapsing and
to stabilise it. The generic answer which has constantly
been brought forth since the collapse of Lehman Broth-
ers seems to be to use fiscal policy to sustain demand,
since monetary policy with its main interest rates ap-
proaching zero will no longer be effective. Fiscal policy
seems particularly appropriate since our macroeco-
nomic models tell us that fiscal policy multipliers in-
crease when more economic agents become liquidity
constrained because they are then likely to spend any
additional income they receive. However, a closer look
at what fiscal policy can actually achieve suggests that
one should be very cautious in expecting too much
from this policy instrument.
As some forecasters are already expecting an upturn
in the second quarter of 2009, Germany‘s stimulus is
likely to be mostly pro-cyclical. The main driver of the
current economic weakness is uncertainty, which made
firms postpone hiring decisions and investment.
3

However, economic and financial uncertainty is now
decreasing, according to all indicators of the finan-
cial fear factor. Obviously, the global policy response
dataset. It is true that radical and unpopular reforms
are difficult when unemployment rises and there is a
strong demand for protection, but it is precisely under
these conditions that one can find support for such dif-
ficult things as reforming public pensions and reducing
the dualism of labour markets. A tentative explanation
for this rather surprising result is that there may be a
stronger perception of emergency when macroeco-
nomic conditions are less favourable – recessions
are often times of “extraordinary politics” – than dur-
ing upturns when lobbies are at work to appropriate a
larger share of the economic “pie”.
Overall, recent European history suggests that it
is precisely now that European governments should
act. It is mainly a matter of national decision-making.
European supranational authorities can support this
process by increasing yardstick competition. They
can also reward those countries that carry out struc-
tural reforms through the allocation of the globalisa-
tion fund. Given the limited size of this fund, it will be
a rather minor economic reward, but may involve a
significant political dividend for the beneficiary. The
largest economic rewards from carrying out structur-
al reforms will come, in any event, from the reduced
costs of servicing the public debt of governments
who succeed in convincing markets that they have
indeed improved the long-term growth prospects of
their economy.
* University of Duisburg-Essen and IZA Bonn, Germany.
Ansgar Belke*
Fiscal Stimulus Packages, Uncertainty and Economic Crisis
Is the Option of Waiting Valuable?
1
European Commission: Interim Forecast, DG for Economic and Fi-
nancial Affairs, Brussels, January 2009.
2
For details see http://www.eurointelligence.com/article.581+M5151
93432ba.0.html. In the meantime, the IMF has come out in favour of
an increase in direct government expenditure and against general tax
cuts. Cf. S. Cl aes s ens , M. A. Kos e, M. E. Ter r ones : What Hap-
pens During Recessions, Crunches and Busts?, IMF Working Paper
08/274, Washington 2008.
FORUM
Intereconomics, January/February 2009 16
to the financial and economic crisis has calmed stock
markets “as the fears of an economic Armageddon
have subsided”. Also, political uncertainty has dimin-
ished as many world leaders have clarified the details
of their stimulus packages.
4
Hopefully, thus, the eco-
nomic medicine has not been administered just as the
patient is striving to leave the hospital!
Depending on their ideological couleur, fiscal policy
proposals by German political parties ahead of the
super-election year 2009 varied from deficit-financed
spending increases, balanced budget spending in-
creases (financed with higher taxes) to deficit financed
tax cuts until the turn-of-year 2008/09. However, these
proposals did not become more appropriate the more
they were contended with increasing frequency and
vehemence. Instead, the long-forgotten political ex-
penditure cycle of the Nordhaus-type appeared to be
back on stage again.
5
Moreover, the stabilising im-
pacts of fiscal policy in general are often largely over-
estimated. The often emphasised multiplier effect of
additional government spending or of temporary tax
cuts is often hardly larger than one.
6
However, in order
to avoid a too Germano-centric perspective, the po-
tential benefits of fiscal policy coordination in the euro
area will be addressed in the following.
The Case of a Liquidity Trap
Policymakers in the EU member states are cur-
rently shaping rescue packages to prevent the finan-
cial crisis hitting their economies with unmitigated
force. Each government seems to be responding to
the emerging problems with a country-specific set of
measures. Given the global nature of the crisis, would
coordinated action at the European level be a better
approach? Or can actions by national governments be
expected to deal more adequately with the problems
facing the national economy than a pan-European set
of measures? The Merkel government in Germany has
even been accused by some of displaying free-rider
behaviour in the area of fiscal policy since it was more
reluctant to push forward large fiscal rescue packages
in the fight against the crisis than its euro area counter-
3
Cf. A. Bel ke, M. Goecke: Real Options Effects on Employment:
Does Exchange Rate Uncertainty Matter for Aggregation?, in: German
Economic Review, Vol. 6, 2005, pp. 185-203; and N. Bl oom: The Im-
pact of Uncertainty Shocks, forthcoming in: Econometrica, Stanford
2008.
4
Cf. N. Bl oem, M. Fl oet ot t o: The recession will be over sooner
than you think, in: VoxEU, 12 January 2009, http://www.voxeu.org/
index.php?q=node/2785. They report that the key measures of uncer-
tainty have dropped so rapidly that they believe growth will resume
by mid-2009.
5
W.D. Nor dhaus : The Political Business Cycle, in: Review of Eco-
nomic Studies, Vol. 42, 1975, pp. 169-190.
6
A. Mount f or d, H. Uhl i g: What Are the Effects of Fiscal Policy
Shocks?, in: NBER Working Paper, No. 14551, Cambridge, MA, 2008.
parts with partly higher debt burdens and often higher
fiscal deficits, and appeared less prone to European
coordinated efforts. Is this negative assessment justi-
fied?
It is widely assumed that a common currency makes
it desirable also to have a common fiscal policy (and
some even go as far as saying that the euro needs to
be backed up by a political union).
7
However, this is not
a foregone conclusion if one accepts that fiscal policy
can also be a source of shocks. There are a variety of
reasons why fiscal policy could be destabilising in the
context of the current crisis: policymakers do not have
full control over the outcome, and at times the effect of
a certain measure (e.g. a tax reform) is quite different
from what is anticipated; or, as in the current situation,
the economic forecasts underlying fiscal policy might
turn out to be wrong. Finally, the large difference be-
tween temporary and permanent fiscal shocks means
that for the effectiveness of the fiscal policy measures
it is of crucial importance that measures are not be-
lieved permanent by private agents. However, the lat-
ter is not always the case.
8
It is thus assumed that fiscal policy represents a
source of shocks. The key question then is whether
a higher correlation of these shocks (presumably be-
cause of tighter cooperation) is desirable. The simple
model used by Belke and Gros
9
which was designed
for “normal” economic periods serves to illustrate a
general idea which should hold up in more sophisti-
cated models as well. Our main result is that in general
it might be better to have independent national fiscal
policies that are not coordinated (or at least not cor-
related) under EMU, because this leads to risk diver-
sification: the variance of a sum of shocks is lower,
the lower the covariance among the individual com-
ponents.
The argument that independent national fiscal poli-
cies are preferable because of risk diversification is
not new and was already documented in the risk shar-
ing literature by Sørensen, Yosha, van Wincoop and
many others.
10
Our analytical results suggest that the
often repeated calls for fiscal policy coordination in
ordinary times might be misguided. More fiscal policy
coordination is also likely to lead to more correlated
7
For a survey on the first issue cf., for instance, P. De Gr auwe: Eco-
nomics of Monetary Union, 6th ed., Oxford 2005, Oxford University
Press; and G. Gandol f o: International Finance and Open-economy
Macroeconomics, Berlin-Heidelberg 2001, Springer. For an introduc-
tion into the second aspect cf. D. Gr os , N. Thy ges en: European
Monetary Integration, New York 1998, Addison Wesley Longman.
8
European Commission, 2009, op. cit.
9
Cf. A. Bel ke, D. Gr os : On the Benefits of Fiscal Policy Coordina-
tion in a Currency Union: A Note, in: Empirica, Vol. 36/1, 2009, pp.
45-49.
Intereconomics, January/February 2009
FORUM
17
fiscal policy shocks and this might increase actual out-
put variability. This result even holds if it is backed by a
more complicated variant of the model used here, one
developed by Belke and Gros, who formally disentan-
gle the discretionary component from the endogenous
(i.e. income dependent) components of fiscal policies
in a monetary union.
11

However, this conclusion is supported by our simple
model structure and holds primarily as long as no other
large shocks emerge. However, in the case of the cur-
rent economic crisis it is reasonable to proceed on the
assumption that an exogenous shock to demand has
hit the euro area countries significantly. With interest
rates converging to zero, this negative shock has signif-
icant external effects which should ideally be internal-
ised by a coordinated effort of national fiscal policies.
However, this way of reasoning decisively hinges on the
existence and significance of a liquidity trap in the euro
area economies. In case of the latter, the spillovers of
fiscal policy are of course positive because the inter-
est rate does not react. Hence, in the Nash equilibrium,
the fiscal stimulus initiated by the euro area countries is
sub-optimally low.
However, the existence of a liquidity trap cannot
be taken for granted. As the saying goes, the German
economy, for instance, is currently on the ropes of a li-
quidity trap. Fearfully, the economic agents are hoard-
ing their cash. Monetary policy, i.e. lower interest rates,
is ineffective in this precarious situation. Is the govern-
ment unable to do otherwise by enacting counter-cy-
clical fiscal policy measures? It is well-known that, with
the notion of a liquidity trap John Maynard Keynes de-
scribed a scenario in which an increasing money supply
is unable to lower bond yields. However, actual data do
not corroborate this view. The recent interest cuts by
the ECB have de facto lowered the returns of govern-
ment bonds rather well. Accordingly, the current yield
of outstanding German government bonds has fallen to
historical lows. Hence, there is no a priori argument – at
least from the German perspective – that fiscal policy is
needed because monetary policy is helpless.
Efficacy of Fiscal Policy
Mountford and Uhlig,
12
for instance, have analysed
three types of policy scenarios: a deficit-financed
10
Cf., for instance, P. Asdr ubal i , B. E. Sør ens en, O. Yos ha:
Channels of Interstate Risk-sharing: US 1963-1990, in: Quarterly
Journal of Economics, Vol.144, 1996, pp. 1081-1110; and B. Sø-
r ens en, O. Yos ha: International Risk Sharing and European Mon-
etary Unification, in: Journal of International Economics, Vol. 45, 1998,
pp. 211-238.
11
A. Bel ke, D. Gr os : Is a Unified Macroeconomic Policy Neces-
sarily Better for a Common Currency Area?, forthcoming in: European
Journal of Political Economy, 2008.
12
A. Mount f or d, H. Uhl i g, op. cit.
spending increase, a balanced budget spending in-
crease (financed with higher taxes) and a deficit
financed tax cut, in which revenues decrease but gov-
ernment spending stays unchanged. Although the best
fiscal policy for stimulating the economy appears to be
deficit-financed tax cuts, they impressively point out
that this should not be read as endorsing them. They
only point out that unanticipated deficit-financed tax
cuts work as a (short-lived) stimulus to the economy,
not that they are sensible. Also, international institu-
tions like the IMF speak out against general tax cuts
and in favour of an increase in direct government ex-
penditures.
13
In sum, also the expenditure part of the
recent German stimulus package is not backed by the
Mountford and Uhlig study.
As always, there are other studies available, some
of them claiming that fiscal policy is more effective
since private consumption is stimulated via a “crowd-
ing in” effect.
14
Some also doubt that the results ob-
tained by Mountford and Uhlig can be transferred on
a one-to-one basis to exceptional situations like the
current crisis, in which many consumers, above all in
the USA, are credit constrained but the latter already
pay little in the way of taxes. Hence it is argued that it
is plausible to assume that firms and consumers will
use tax cuts first of all to clear up their balance sheet.
However, Daniel Gros shows in his contribution in this
volume that this kind of argument is applicable only
to a few EU countries, particularly the UK and Spain.
Taken on the whole, it thus appears that Germany’s Fi-
nance Minister Mr. Steinbrück was not too mistaken
with his long-lasting reluctance vis-à-vis the demands
for extensive deficit spending earlier in 2007/2008. But
waiting with fiscal stimulus packages (with, of course,
the option to conduct them later on) can also be valu-
able simply due to the existence of uncertainty. But of
what type?
Model Uncertainty and Forecast Uncertainty
Issing,
15
for instance, distinguishing three broad
categories of uncertainty, from the more common to
the more complex and “Knightian” ones, acknowl-
edges that the uncertainty factors faced by those re-
sponsible for macroeconomic policy are myriad and
interdependent. They are created by, for instance,
competition between different theoretical models or
13
A. Spi l i mber go, S. Sy mans ky, O. J. Bl anchar d, C. Cot -
t ar el l i : Fiscal Policy for the Crisis, in: International Monetary Fund,
Staff Position Note, SPN/08/01, Washington, DC, 29 December 2008.
14
T. Monacel l i , R. Per ot t i : Fiscal Policy, Wealth Effects, and
Markups, in: NBER Working Paper, No. 14584, Cambridge,MA, 2008 .
15
O. I s si ng: Monetary Policy in a World of Uncertainty, in: Fondation
Banque de France Centre d’Etudes Prospectives et d’Informations In-
ternationales CEPII Université Aix-Marseille IDE, Paris, 9 December
2002 (http://www.banque-france.fr/gb/fondatio/telechar/issing.pdf).
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Intereconomics, January/February 2009 18
structural change. The latter type of model uncertainty
has gained a new dimension in the wake of the current
crisis. Some analysts fail to appreciate that the appro-
priate macroeconomic models are currently suitable
neither for forecasting nor for evaluating policy meas-
ures.
None of the relevant macro models had foreseen
and predicted the financial crisis of 2007/08, inter
alia because this kind of model does not contain the
currently decisive variables such as venturesome-
ness and credit growth. Hence, model based policy
consulting by and large does not appear to be able to
answer the question of how to fight the fallout of the
crisis, the question that had it stumped. Starting from
this background it is either a remarkable irony of his-
tory or a clear but probably unintended case in favour
of the Lucas critique
16
that those institutions which still
forecast a deep enduring international crisis are those
which demand fiscal stimulus packages the most
pressingly and see them going into effect by now.
A great bulk of the aforementioned macroeconomic
models cannot be applied under the current circum-
stances and business cycle forecasts are currently af-
flicted with a still rather high degree of uncertainty. This
is due not least to the vagueness of the extent and the
effects of the worldwide reactions of economic policy
to the crisis. The estimations of German growth are
all within the negative spectrum. However, their range
has been unusually high. While some “only” come up
with a contraction of 0.5 per cent, others no longer ex-
clude a minus four. At present, the only reliable fact is
that aggregate demand still appears to be weak.
The Option Value of Waiting
It has increasingly been argued in recent weeks
that, in spite of all imponderabilities, enacting large
economic stimulus packages is justified since govern-
ments should at least try to stabilise the economy; at
the very least it could do no damage. However, this
argument is not completely consistent. If such meas-
ures are enacted today, for instance in the shape of
deficit financed tax reductions, future additional pro-
grammes become even more expensive because the
level of public debt will then be higher, although these
programmes might be needed even more pressingly.
And in reality, German government debt is heavily in-
creasing these days. It is already likely that Germany’s
new borrowing in 2009 will not be below the Maas-
tricht level. Even worse, the promise of an all-embrac-
ing tax reform after the federal elections will probably
not be kept.
16
R. E. Lucas : Econometric policy evaluation: A critique, in: K.
Br unner, A. H. Mel t z er (eds.): The Phillips Curve and Labour Mar-
kets, in: Journal of Monetary Economics(Suppl.), 1976, pp. 19-46.
Even Higher Debt Levels after Fiscal Package
Deals
Each tax cut included in the stimulus package II
lowers the leeway for future tax reforms, since tax cuts
cannot be planned without an eye on government debt.
Thus, the most effective prerequisite of future tax cuts
is Germany’s strict compliance with the Maastricht cri-
teria. The German government therefore should now
provide for a quick (basic law) statutory anchored debt
brake in the federalism reform II. A prototype example
of the immense future costs of self-defeating deficit fi-
nanced fiscal packages is Japan, where the different
fiscal policy measures in the 1990s have led to a mas-
sive increase in public debt which will continue to bur-
den Japanese citizens for decades and which makes
current fiscal policy measures much too expensive in
terms of costs of repayment.
17
Especially in times of great uncertainty it thus makes
sense to wait somewhat with the implementation of
expansionary policy measures such as tax cuts and
expenditure programmes until the fog of the forecast
uncertainty has lifted and it has become clear how
large the economic crash really is. However, in extreme
times like the present business cycle forecasts are not
of much help. They contain a good deal of specula-
tion and cannot serve as a sound quantitative basis for
the adequate dosage of counter-cyclical fiscal policy
packages. In order to avoid becoming an amplifier of
the crisis itself, a government should, at least tempo-
rarily, follow the Knightian approach to uncertainty and
rely more than usual upon qualitative analyses.
The German government therefore deserves sup-
port for its approach up until 12 January, to gain more
evidence about the effects of the already initiated
steps and of the automatic stabilisers for the time be-
ing. However, this wait-and-see attitude has not pre-
cluded working on plans for a contingency budget
(„Eventualhaushalt“) with longer term expenditure pro-
grammes in the areas of infrastructure, research, edu-
cation and family issues. This still allowed the option
to act quickly as the crisis and the awareness thereof
became even more intense. However, it had to be de-
termined how the expected large budget deficits were
to be compensated by additional government savings
after overcoming the crisis. Until today, it is not clear
how credible this is. Anyway, with an eye on the option
value of waiting, the German Grand Coalition was well
advised until the end-of-year 2008 to keep its powder
dry for the crisis year 2009. If the pessimists among
17
Cf. Kenneth Rogof f at the AEA 2009 Meeting, American Eco-
nomic Association, Proceedings of the Annual AEA Meeting in San
Francisco, 2009, http://www.vanderbilt.edu/AEA/Annual_Meeting/
index.htm.
Intereconomics, January/February 2009
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19
the forecasters at that time were to be believed, the
German government would be in need of it.
18
Hence,
from the perspective of the option value of waiting
under uncertainty and assuming that uncertainty was
still high and the package was not large and effective
enough, the German government killed its option too
early on 12 January 2009.
Investment, Consumption and Uncertainty
Pressure on the European governments to increase
spending or to cut taxes is growing as mid-term growth
prospects for the euro area worsen. The arguments for
a further cut in interest rates and a large fiscal stimu-
lus seem compelling: inflation is now clearly below the
ceiling set by the ECB itself and demand is so weak
that there is no danger of fiscal policy induced pres-
sure on prices emerging in the near future. Moreover,
some argue that especially for Germany there is ample
room for fiscal manoeuvre. However, this view is mis-
guided since already in 2009 an estimated budget def-
icit beyond the Maastricht limit of three per cent is not
impossible. Finally, amid the uncertainty over the size
of the real effects of the financial crisis, the euro area
economy is arguably in need of some stabilisation. But
how large is uncertainty at the moment really?
How Large is Uncertainty at the Turn-of-the-year
2008/09?
However, a closer look at the economic effects of
uncertainty suggests that this might be a poor strategy
around the turn-of-the-year 2008/09 – especially be-
cause uncertainty in the markets is still extraordinarily
18
S. Cl aes sens, M. A. Kos e, M. E. Ter r ones , op. cit.; and Deut-
sches Institut für Wirtschaftsforschung: Wochenbericht, Vol. 76, No.
1-2, 2009, Berlin, 7 Januar 2009.
high, though on its way down. In the case of Germany,
the relevant type of financial and economic uncertain-
ty is traded via the VDAX which delivers the implicit
45 day-ahead volatility of German stock futures (DAX)
in per cent. High empirical realisations point to a still
restless and irregular market, low empirical realisations
lets one expect a further stock market performance
without strong price fluctuations. Hence, the VDAX is
frequently called the “barometer of fear”.
The actual figures reveal a positive structural break
in the data since 25 August 2008, which still matters
up to now (Figure 1). The VDAX jumped over fourfold
after the dramatic collapse of Lehman’s in September
2008. But it has fallen back by 50 per cent over the
last couple of weeks as both economic and political
uncertainty has receded. Alternative measures of un-
certainty such as the implied volatility on the S&P 100
which is commonly known as the financial “fear fac-
tor” have also fallen.
19
This is even true with respect to
the frequency of the use of the expression “uncertain”
in the press.
20
However, in the same way as business cycle fore-
casts are currently afflicted with a continuingly high
degree of uncertainty, indicators of financial fears are
not reliable early business cycle indicators. Hence, it
appears definitely too early to argue that (a) Germany
has recently shifted to a less pronounced uncertain-
ty regime since all actors have become aware of the
potentially huge dimensions of the crisis and (b) one
should have agreed only three months ago with ana-
lysts like Paul Krugman
21
who warned that a dire re-
cession was brewing.
One important implication of the model of the op-
tion value of waiting is that only the current short-term
uncertainty has an impact on the decision to wait. Fu-
ture uncertainty does not enter the decision under risk
neutrality. If one takes a fixed period, for instance one
year, the likelihood that investment will be postponed
to the end of that period depends only on the uncer-
tainty during that period and not on future uncertainty.
This implies that even short spikes in uncertainty can
have a strong impact on investment. This simple mod-
el view abstracts from risk aversion. However, Belke
19
Cf. N. Bl oem, M. Fl oet ot t o, op. cit.
20
Cf. M. Al exopoul os , J. Cohen: Uncertainty and the credit
crisis, in: VoxEU, 23 December 2008, http://www.voxeu.org/index.
php?q=node/2732, claim that uncertainty shocks have a swift, strong
and durable impact on economic activity. Assessing expectations of
average citizens in Main Street through the use of keywords in main
newspapers indicates a modest decline of uncertainty since October
2008, suggesting that “the worst may be behind us”.
21
P. Kr ugman: Ideas for Obama, in: New York Times, Opinion, 11
January 2009.
Sour ce: Thomson Financial Datastream.
Figure 1
“Barometer of Fear”: the DAX Volatility Index
(VDAX) 2007-2009
0
10
20
30
40
50
60
70
80
90
J
a
n
-
2
0
0
7
A
p
r
-
2
0
0
7
J
u
l
-
2
0
0
7
O
c
t
-
2
0
0
7
J
a
n
-
2
0
0
8
A
p
r
-
2
0
0
8
J
u
l
-
2
0
0
8
O
c
t
-
2
0
0
8
J
a
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-
2
0
0
9
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Intereconomics, January/February 2009 20
and Gros
22
show that the basic conclusion that even
a temporary increase in uncertainty can make a post-
ponement of investment optimal is robust to the intro-
duction of risk-adjusted discount factors.
Skeptics towards this approach might argue that
there are two effects working in the opposite direction
which are relevant in the current situation. On the one
hand, there is a still extraordinarily high economic and
financial uncertainty which increases the “play” area of
weak reaction by macroeconomic variables to chang-
es in macroeconomic policy. On the other hand it has
become increasingly clear in recent weeks that the bad
realisation becomes more and more probable and the
increasing deviation from the fifty-fifty probability as-
sessment diminishes the “play area“. This means that
the two effects currently run against each other and
the net effect is not clear yet. However, we have shed
much more light on this issue in Figure 1 by means of a
look at the current prices at which financial uncertainty
is traded these days. This has confirmed that it is still
tremendous. Hence, it seems legitimate to argue that
one disposes of a high uncertainty threshold to trig-
ger on the option argument. Equally, evidence of an
“option value of waiting” for monetary and fiscal policy
should emerge since we still find ourselves in a period
of extraordinary uncertainty.
To deal with the influence of uncertainty on econom-
ic decisions, economists have developed the concept
of the “option value of waiting under uncertainty”.
23

This formalises a common-sense rule: if a decision in-
volves some sunk costs, or any other element of irre-
versibility, it makes sense to wait until the uncertainty
has been resolved. The temptation to postpone invest-
ment decisions is particularly strong when the uncer-
tainty is likely to be resolved in the near future (as, for
instance, by fiscal packages!) This conclusion appears
to be independent of the assessment of uncertainty
as a stochastic or a Knightian phenomenon. Why are
we talking about “Knightian uncertainty”? Because
Keynes is back, at least according to many scholars,
and the sense and nonsense of counter-cyclical fiscal
packages in times of uncertainty have to be discussed
from the Keynesian perspective as well.
While the academic profession, among others Dixit
and Pindyck,
24
has made tremendous progress in ana-
lysing risk and uncertainty in well-defined stochastic
22
Cf. A. Bel ke, D. Gr os : Real Impacts of Intra-European Exchange
Rate Variability: A Case for EMU?, in: Open Economies Review, Vol.
12, No. 3, 2001, pp. 231-264.
23
A. Di xi t , R. S. Pi ndyck: Investment under Uncertainty, Princ-
eton, New York 1994.
24
Ibid.
economies, the “Knightian uncertainty” that confronts
monetary policy and sometimes markets is of an alto-
gether different dimension. It was US economist Frank
Knight (1885 – 1972) who, in his book “Risk, Uncer-
tainty and Profit”, built his analysis on the distinction
between risk and uncertainty:
25
“Uncertainty must be
taken in a sense radically distinct from the familiar
notion of Risk, from which it has never been properly
separated … It will appear that a measurable uncer-
tainty, or “risk” proper … is so far different from an un-
measurable one that it is not in effect an uncertainty
at all.”
Knight speaks of no less than the failure of the con-
cept of probability calculus. In his seminal work “The
General Theory of Employment, Interest and Money”,
John Maynard Keynes (1883-1946) takes a very simi-
lar stance:
26
“[Most of our decisions] to do something
positive … can only be taken as a result of animal spirit
… and not as the outcome of a weighted average of
quantitative benefits multiplied by quantitative prob-
abilities.” In fact, Knight argues that the difficulty of the
forecasting process extends far beyond the impossi-
bility of applying mathematical propositions to fore-
casting the future. A priori reasoning, Knight insisted,
cannot eliminate indeterminateness from the future.
In the end, he considered reliance on the frequency
of past occurrences extremely hazardous.
27
This as-
sessment fits extremely well with the current situation
and would a fortiori lead to the same assessment of
the (non-) usefulness of macro stimulus packages of
a magnitude below a certain threshold in the current
crisis according to the concept of the option value of
waiting under uncertainty.
“Option Value of Waiting” for the Government
It is clear that any decision to increase government
spending and/or to lower taxes involves some sunk
costs, or some other element of irreversibility. First, it
takes time to pass the fiscal measures through the na-
tional Parliaments and for the economy to respond.
28

As a result, once decided, the fiscal policy measures
can rarely be adjusted to the changing economic cir-
cumstances. Second, there are always some political
constraints: it tends to be much easier for govern-
ments to ease fiscal policy than to tighten it, from the
perspective of political economy a reversal is not cred-
25
Cf. F. Kni ght : Risk, Uncertainty and Profit, New York 1964, 1921,
Century Press.
26
J. M. Key nes : The General Theory of Employment, Interest and
Money, New York 1936, Harcourt, Brace.
27
Cf. A. Bel ke, T. Pol l ei t : Monetary Economics of Global Financial
Markets, forthcoming 2009, Springer.
28
Cf. M. But i : The Economic Downturn and Budgetary Policy in Eu-
rope, Mimeo, 2001.
Intereconomics, January/February 2009
FORUM
21
ible, the package is package-deal specific and once
the measure is taken it tends to become irreversible.
A third important aspect is the following. Germany
as it stands now, i.e. after having decided on the sec-
ond fiscal package, will have consolidated its debt no
earlier than sometime around 2020. Anyway, consoli-
dation will not be a pleasant enterprise since Germany
will have to cope with the economic consequences
of demographic change. And the ongoing weakness
of the stock markets will almost certainly not quicken
Germany’s political pace towards a stronger adop-
tion of private pension schemes. Hence, the process
of debt accumulation by expenditure programmes is
most probably asymmetric and, thus, can be regard-
ed as at least partly irreversible. However, the option
value of waiting in times of uncertainty is not limited to
the government but also extends to private agents.
“Option Value of Waiting” for Private Agents
You can imagine businesses assessing investment
projects that would be slightly profitable under current
circumstances, even more profitable if the uncertainty
were favourably resolved, and loss-making if not. Such
a business would lose little (in terms of forgone profits)
if it delayed the decision. Once the uncertainty had
been resolved, it would still have the option to proceed
if that was to its advantage. An analogous argument
applies to the consumers who might delay their deci-
sions to buy, for instance, a durable consumer good
in times of high uncertainty (of being employed at all in
the near future. This uncertainty makes it worthwhile
to postpone consumption and to wait for even lower
prices). According to some other simple models, un-
certainty which cannot be hedged raises the variability
of revenues and induces the investors to apply a high-
er discount rate on (expected) future revenues.
29

At the start of the financial (subprime) crisis it was
argued that it would not have any appreciable di-
rect consequences for the European economy since
Europe, having significantly extended its trade with
emerging markets, had probably de-coupled from
the USA in terms of the business cycle. However, as
time went by it was recognised that the indirect effects
could be substantial if the crisis lasted longer than ex-
pected, or if it led to a disruption of the banking sector
and some branches like the car industry, i.e. to wider
regional financial and economic instability. A long and
deep recession cannot be excluded a priori. This ex-
plains why the financial crisis weighs so heavily on
29
For simplicity, discounting issues and risk aversion are ignored here
(on this cf. A. Bel ke, D. Gr os , 2001, op. cit.) so that decisions can
be based only on expected values. The same assumption is used also
by A. Di xi t : Entry and Exit Decisions under Uncertainty, in: Journal of
Political Economy, Vol. 97, 1989, pp. 620-638.
many apparently unrelated decisions. This uncertain-
ty is likely to be completely resolved in the medium
run, perhaps not in a matter of months, as some ana-
lysts maintain, but certainly in a matter of one or two
years. However, while it remains, one would expect
demand – especially investment demand – to remain
quite weak in the near future.
“Option Value of Waiting” for the Fiscal
Authority – a Deeper Analysis
So should a government then not try to stimulate
demand with a fiscal shock, as for instance a defi-
cit-financed spending increase, a balanced budget
spending increase (financed with higher taxes) and
a deficit financed tax cut in times of large financial
and economic uncertainty? A first argument against
this approach would be that the concept of the „op-
tion value of waiting“ applies to a government just as
much as it applies to everyone else. A deep reces-
sion which has the potential to turn into a depression
may be averted, or it may be relatively short and have
little durable effect on important macroeconomic var-
iables such as the labour market. Hence, if the gov-
ernment triggers another fiscal policy shock within
the coming months, it risks having to reverse its deci-
sion almost immediately if the crisis turns out to be
relatively short-lived or – if financed by inflation - in
order to avoid blowing up the next asset price bub-
ble.
30
The government should thus trigger a positive
fiscal policy shock only if it is convinced that such a
shock will make sense even if the uncertainty about
the length and the duration of the crisis is favourably
resolved.
In the context of the financial crisis of 2007/08 and
the potential 2009 depression, a fiscal policy shock as
an insurance against a bad outcome does not make
sense since:
Fiscal policy shocks are not effective if uncertainty 1.
is large.
The government itself disposes of an option value 2.
of waiting with fiscal policy shocks. If, for instance
the government shocks “today”, it kills the option
to shock in the future (although this option might
be very valuable in times of high uncertainty).
Frequent fiscal policy changes by a government 3.
induce additional uncertainty, which tends to ag-
gravate the current weakness of investment and
consumer goods demand.
30
A. Bel ke, W. Or t h, R. Set z er : Sowing the Seeds of the Sub-
prime Crisis – Does Global Liquidity Matter for Housing and other As-
set Prices?, in: International Economics and Economic Policy, Vol. 5,
No. 4, 2008, pp. 403-424.
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Intereconomics, January/February 2009 22
Seen on the whole, the above analysis has a clear
bearing on the current discussion about the crisis
management of the world’s leading fiscal authorities
with respect to the US-driven financial and economic
crisis. If, in times of high uncertainty about the risks
finally faced by firms, households and the economy as
a whole, the government triggers fiscal policy shocks
in a stepwise fashion, it does not induce more than a
straw fire on the stock markets and the entire econ-
omy for several days but certainly does not induce a
sustainable move towards more investment and con-
sumption demand, which is so urgently needed to pre-
vent a world recession.
31

Thus, starting with the above-mentioned irrevers-
ibilities which are specific to fiscal policy, great uncer-
tainty also generates an option value of waiting for the
fiscal authorities. The pleas of the majority of speakers
at this year’s AEA Conference 2009 in San Francisco
in favour of significant increases in government ex-
penditure do not appear to be in contradiction to this
assessment because they almost exclusively refer to
the much more flexible US economy.
32
Applying this
argument to continental Europe is certainly not admis-
sible. Newspapers worldwide reported in the wake
of the AEA Meeting that many US economists inter-
preted a large but arguably transitory increase in direct
government expenditures as the most important insur-
ance against a “Great Depression II”. However, real
options theory teaches us that, at least in Europe, a
cut in taxes or an increase in expenditures as an insur-
ance against a bad outcome does not make sense, just
as little as a cut in central bank interest rates is useful
for this purpose.
The Band of Inaction
The models of decision-making under uncertainty
also have a second implication. All decisions involve
some transaction costs – whether they concern in-
vestment, hiring and firing, or bureaucratic sclerosis
in general. The latter are especially important in con-
tinental Europe (although Germany has made some
progress in lowering labour market rigidities in recent
years due to the Hartz reforms). This implies that busi-
nesses facing only a small change in prices may not
respond immediately. There is always a band of in-
action – a price range within which it does not pay to
change course. The size of this band of inaction in-
creases as uncertainty increases. And, given the still
31
For a general discussion of interest rate decisions in an uncertain
environment cf. D. Begg, F. Canov a, P. de Gr auwe, A. Fat ás , P.
Lane: Surviving the Slowdown, in: Monitoring the European Central
Bank 4, Centre for Economic Policy Research (CEPR), London 2002.
32
Cf. American Economic Association, 2009, op. cit.
prevalent structural rigidities in the euro area economy,
uncertainties probably affect decision-making in Eu-
rope more than they do in the USA. Hence, one should
not be trapped in the currently quite popular fallacy
that Keynesian demand stimulation will be successful
in Europe only because it appears to work in the USA.
Due to the extraordinarily high degree of uncertainty,
real world investment, employment and consump-
tion may appear less sensitive to changes in the fiscal
policy stance than according to the prediction of the
majority of models of fiscal policy transmission.
Instead, for instance the increasingly apparent debt
problems in the euro area suggest that the government
should stay its hand. But if the government is not con-
vinced of this, it should avoid shocking a little today,
because that would not be a sensible compromise
in times of still high uncertainty; in fact, it would just
waste an option without helping the economy. Instead,
one could make the case for a stronger fiscal policy
response. As the Germans say, “Klotzen nicht Kleck-
ern”: if you are going to hit it, hit it hard. That might
be correct in principle, but policymakers would need
to (re-)act fast. Any additional economic stimulus has
to be implemented quickly. Dithering over different di-
rections of policy might actually make things worse by
adding uncertainty.
33

However, common sense tells us that acting ac-
cording to the motto “It’s now or never for expansion-
ary policy” is not really an option, at least in the case
of Germany, simply because it might be too late for
such a large stimulus. Now that uncertainty is gradu-
ally decreasing, growth should start to rebound and
a large stimulus will no longer be needed. Firms will
probably begin to hire and invest again to make up for
lost waiting time. Abstracting from real option theory
under uncertainty, one should advise against a large
stimulus anyway – mainly with an eye on too high and
unsustainable debt levels. Moreover, abstaining from
over-expansionary fiscal policies in interplay with
monetary policy which inflates the economy in order
to push down real debt avoids sowing the seeds of the
next asset price bubble and the subsequent crisis.
The government is just painfully caught between the
conflicting alternatives “to react quickly” or “to wait
with fiscal stimuli”. The above analysis has shown that
the specific way out should depend on the magnitude
of the planned package, on the estimated degree of
uncertainty prevailing and on the credibility of later
consolidation.
33
Cf. R.J. Cabal l er o: Normalcy is Just a Few Bold Policy Steps
Away, MIT, mimeo, 17 December 2008.

To justify this. Three Criteria to Judge a Fiscal Stimulus Higher public deficits shift the tax burden onto future generations.intereconomics. and experts from industry and politics (mainly by invitation) • Articles: Papers concerned with economic policy issues and trends • Economic Trends: Analyses of business cycle trends Call for submissions Authors are invited to submit papers for the articles section that make a contribution to policy debates in the EU or its Member States. taxpayers in the Western world can thus collectively borrow at unusually attractive rates while. governments can satisfy the increased demand for government bonds and raise consumption more Intereconomics.preissl@zbw. CEPS editor Felix. please go to: http://www. blanks). • it has to improve the long-term growth potential so that future gains in tax revenues make it easier to reduce the public debt again afterwards. By running higher deficits and augmenting aggregate demand.eu. editor-in-chief b. with locations in Kiel and Hamburg. It is distinguished by a strong in-house research capacity covering all major policy domains of the EU. from the individual to the collective level. Please contact: Brigitte Preissl. During such a period of tight credit conditions for the private economy.eu Tel: +32 2 229 394 3 tries had qualified to join Economic and Monetary Union. with the aim of making the prestigious journal the leading forum for research-based discussions of major European economic policy issues. This is the second argument in favour of a fiscal stimulus in the current situation. it can thus pay to outsource some of the consumption smoothing. For details and more information on the Intereconomics profile. that is the temporary borrowing in a downturn. Acting through their governments. a fiscal injection has to meet three criteria: • it has to be fast to actually help while the economy needs it most. Its mission is to procure and supply economic information and literature nationally and to offer its users comprehensive services that will facilitate efficient and effective utilisation of economics-specific information. Intereconomics – Review of European Economic Policy is a platform for economic and social policy debates in Europe. It represents over 40 years of economic policy oriented publishing. +49 40 428 34 306 or Felix Roth. January/February 2009 cheaply than households could if they were to borrow themselves. They should be between 3 000 and 8 000 words in length (18 500-50 000 characters incl.roth@ceps. even these countries can still finance themselves at much lower nominal yields than usual.eu Tel. Papers should be written in English and should not have been published elsewhere. the Centre for European Policy Studies (CEPS) is one of the most experienced and authoritative think tanks operating in the European Union today.FORUM Announcement Intereconomics: New partnership between ZBW and CEPS The German National Library of Economics (ZBW) is joining forces with the Centre for European Policy Studies (CEPS) in the publication of Intereconomics. individually. complemented by an extensive network of partner institutes and associated researchers throughout the world. ZBW is the world’s largest specialist library for economics. 5 . The journal is organised into 3 sections: • Forum: Policy debates on highly topical themes based on short contributions from researchers. Founded in Brussels in 1983. they face unusually tough credit constraints.

There simply was no way to find a general mechanism to determine the price at which troubled assets. the two contenders for his succession. Ireland shocked its neighbours by doing what Sweden had successfully done in late 1992 to prevent a ruinous run on its banks: it guaranteed all bank deposits on 30 September 2008. The Uturn became obvious by 14 October. This carries a lesson for fiscal policy: in theory. Being forced to react to each others’ unilateral moves. As it turned out. In this respect. The US Administration proposed a massive programme to take bad assets off the balance sheets of banks (troubled assets relief programme. the central bank. First. Other countries also started to seriously discuss national bank bailout plans. Like the Irish coup. returning to the idea of shifting the risk of troubled assets from banks to the government for a fee. German chancellor Merkel – apparently on new information about the problems of some German banks – assured all Germans that their deposits were safe. Europe used its diversity and its internal divisions to its advantage. Shortly thereafter. The result sent financial markets into a tailspin. When even this did not seem to help enough. with much less subsequent need to correct design flaws afterwards. learning from one another by seeing close-up what seems to work – or not work – in one country. the programme foundered in a first vote in the US Senate on 29 September. Now look at the messy ways of crisis control in the European Union. the TARP had a central design flaw. Over time. this unilateral move raised eyebrows across Europe. A first Paris summit failed spectacularly to agree on a common European position on 4 October 2008. The USA thus could act fast and forcefully. But what happened then? Initially. Within three days. sometimes behind closed doors. most West European countries then came up with national bailout programmes based to a significant degree on the British example while taking national peculiarities into account. But it did still show Europe at its best. both houses of parliament passed a modified version. January/February 2009 . The political process in Europe certainly was not pretty. The 6 resulting flow of deposits from British banks into Irish banks infuriated the UK authorities and forced them to accelerate their own crisis response. sometimes openly. except for the unspecific promise to let no major bank fail in Europe and de facto suspension of the fiscal deficit limits enshrined in the European Stability and Growth Pact.FORUM • it should minimise the risk that it gets hijacked by special interest groups. the financial regulators and the two chambers of parliament. Competition. But it also forced other European governments to look even harder at the issue. imitation and an institutional setting which reduces the risk of solving national problems too much and too openly at the expense of one’s neighbours due to the frequent interaction of the various national leaders on a wide variety of issues (repeated games) are the hallmarks of the European approach. Britain then came up with a comparatively sensible anti-crisis programme on 8 October. an offer to recapitalise banks with public money and to guarantee bank funding for three years. the USA finally changed tack again. the US Administration changed the nature of the $700 billion TARP programme completely. the central bank. which had become untradable. The messy European way delivered better results. A key issue is whether a joint European Union fiscal programme has a better chance to meet these criteria than a motley collection of independent national measures. national stimulus programmes may be suboptimal because they may not take trade and finance linkages Intereconomics. using the money to inject capital into banks and to guarantee banks against losses instead. Despite full support from President Bush. And it did when the Administration realised the extent of the problem. Other European countries endorsed the main principles of it at a Eurozone summit meeting in Paris the Sunday thereafter. a comparison between the centralised US response and the largely decentralised European response to the immediate banking crisis in late September and October 2008 is quite revealing. de facto promising a blanket deposit guarantee. the regulators and countless financial market experts. Financial Bailout Programmes: A Revealing Example The USA seemed to have all the advantages: one central administration staffed with financial market experts at the highest level who could rely on well-established procedures of cooperation between the Treasury (finance ministry). could be taken off the books of banks. the European Union ended up within a few weeks with a set of largely compatible national bank bailout programmes. it was the Swiss example – that is the tailormade rescue package of the Swiss National Bank for UBS – which provided the blueprint for how the US authorities finally ended up dealing with the problems of major banks on a case-by-case basis. including enhanced deposit guarantees. hardly anything. than the centralised “grand-design” US approach. Right after her return from Paris. 12 October 2008. In the end. Instead of trying to devise one joint approach from the very beginning. TARP) on 19 September 2008.

For instance. explains that public spending on domestic projects minimises the “leakages” into savings and imports. Public Investment Programmes In theory. it might do harm rather than good.FORUM within the European Union fully into account. National Fiscal Programmes This brings us back to the question which kind of fiscal response could make sense. the European institutions could and should still play a role. if fully implemented. with a central design. the theoretical case for a fiscal stimulus is stronger than usual due to the extraordinary nature of the current downturn in which the transmission mechanism of monetary policy is impaired and the private sector faces unusually tough credit constraints. namely time. is far too great. How would. January/February 2009 Brussels is to be the guardian of the Treaties. Whether or not a European parliament may eventually take over this responsibility in a few generations’ time is a mute question for the time being. a common European fiscal response to the crisis would most likely be more flawed in its design and even more belated than national fiscal programmes tend to be anyway. Standard Keynesianism as taught in the textbooks of the 1970s and 1980s (the formative years of most decision makers today). The Forbidding Politics of a Common European Boost Now turn to the genuine politics of a joint European fiscal response. As such. Unfortunately. In addition. German cities used generous grants of such federal investment programmes to build splashy new swimming pools. or what governments could sensibly do at home. public investment programmes could make most sense. If the pursuit of it distracts attention from what needs to be done in other fields of policy. The probability that. would yield better results than individual national programmes. delivering a boost to demand well beyond the extra fiscal expenditure. European institutions should leave the fiscal response to the severe recession – or the absence of such a response – to the member states. and respect for some basic common rules. even abstracting from the costs that an ill-designed European initiative would place on taxpayers of the future. We need not even get into the history of the Common Agricultural Policy to find further examples to make this lesson. for instance. say. Europe could simple get it wrong. no national fiscal stimulus should have a payout only for buying a domestic car. In short. National actions with some minimum coordination. the EU institutions should fulfil their normal task of enforcing some common non-discrimination rules. However. are less risky. As discussed before. decisions on how much to tax and spend are the prime prerogative of national parliaments. But beyond that. Germany had twice granted its neighbours and friends their wish to add to global demand by a German stimulus at home. only to close many of them again a little later when they could not afford to pay the lifeguards and other running costs out of their own city pockets. Against the better judgement of many German officials. Precious time is usually wasted in devising the programmes. not on those of the smaller EU newcomers. Britain rejected a programme that is designed to work only if all key players take part? Would Germany still play ball. those who get paid for building them. briefly. That is a tall order indeed. Of course. The multiplier effect is thus big. the process often falls prey to special interest groups in the lengthy parliamentary deliberations about spending priorities. We focus our discussion mostly on the situation in and experiences of some of the bigger and long-standing EU members. the practical experience with such crude Keynesian experiments across the world is dismal. Both the locomotive experiment of the late 1970s and the much smaller “echo easing” of 7 . And support for financial institutions should not distort competition on financial markets by too much and for too long. wasting a commodity that – in the fiscal crisis response – is even scarcer than money. National circumstances differ. The fate of the Lisbon Treaty does not make us very confident that a pan-European fiscal approach could make it through the national approval processes intact and in time. But the chance to learn from one another reduces the risk that a flawed grand design could be adopted. In the 1970s for instance. A European stimulus programme would thus have to be passed by the parliaments of all major member states. The process can result in the proverbial “bridges to nowhere” which help no one at all except. A joint European fiscal programme is thus simply a bad idea. knowing that it would not get its quid-pro-quo from the other side of the English Channel. Berlin react if. The most noble function of Intereconomics. Imagine that a committee of experts had indeed been able to design a grand European fiscal programme which. This already points to a further obvious drawback of a joint European fiscal response: adding a European layer of preparation and decision making would likely retard the overall process.

German disposable incomes were up 3. 8 . many Germans may simply have saved the extra money to provide for future tax increases (Ricardian equivalence). it would encourage employers to make more use of labour. Such tax cuts would be worth the longterm fiscal cost. Slashing the payroll taxes aggressively would enhance the purchasing power of working consumers. raising their savings rate from 10. according to standard Keynesian logic. Of course. The German Example On 12 January. take the case of Germany. But Tax cuts can be passed quickly. Apart from this volatility. such as a temporary reduction in the VAT. those changes which. and likely some negative impact on the incentives to work instead. leaving special interest groups less time to interfere. are most likely to work because they enhance the spending power of low-saving households (tax rebate checks. It would also cut labour costs for employers. In the short-term. Helped by still-rising employment and less subdued wage gains. However.1% year on year on the third quarter of 2008. January/February 2009 For details see Herbert G i e r s c h . for instance in the form of tax rebate checks. many Britons will probably go on a spending spree for durable consumer goods in late 2009 and make up for it by not buying such goods after the return to the higher VAT rate at the start of 2010. a cut in these taxes would benefit high-income households proportionally less than a general reduction in income tax rates would. In both cases. As the taxes are capped at a certain level. The country has fallen into a deep recession because demand for its highly cyclical exports of flashy cars and quality machinery has collapsed.7% of their disposable income in the autumn of 2007 to 11. Again.4% in the third quarter of 2008 instead. this would enable them to keep a few more workers on their payrolls throughout the recession. The point is that Germans are not spending the money they have. can help to bridge the time gap until the monetary stimulus starts to work. which are split in equal measure between employers and employees. Karl-Heinz P a q u e . Tax cuts can be implemented much faster and have a chance to work better than simply raising government spending. there are tax cuts which could both deliver an effective fiscal boost and be considered “fair”. If Germany had followed Britain (temporary VAT cut until the end of 2009 while announcing at the same time that taxes would have to go up significantly in the years thereafter). Cutting payroll taxes could thus beat the simple Ricardian equivalence. Other tax cuts. Our verdict on tax cuts to combat the recession is thus ambiguous. a factor of production that is still underemployed in most European countries with their comparatively high rates of unemployment. enhanced welfare benefits and income tax cuts focussed on low-income households) are often the ones with no positive impact on incentives at all. even in Britain. Judging by the German experience with the VAT hike of 2007. Even under Ricardian equivalence. especially as an enhanced growth and employment potential would eventually reduce the fiscal costs. Well-designed tax cuts. Tax Cuts: Yes. Incidentally. much of the additional earmarked resources were spent when the economy was already recovering from the worst of the downturn which had triggered international calls for a German fiscal boost. triggering a major retrenchment in investment in export-oriented industry. a good way to mitigate at least a little the mounting fears of unemployment which are likely to weigh on consumption. the major impact of the VAT hike could be to distort the pattern of consumption at the turn of the year 2009/2010. More importantly. The key elements are extra infrastructure spending (€18 billion for the two years taken toIntereconomics. whether or not tax cuts will actually work depends very much on the nature of the cuts and on national circumstances. raising consumption through tax cuts could be an obvious remedy. chapter 5A. 2 The case for tax cuts is strongest if such cuts enhance the incentive structure of the economy and thus raise the trend rate of growth. German coalition leaders sealed a deal on a €50 billion fiscal stimulus programme for 2009 and 2010. German consumers do not lack the money to spend. the overall effect on consumption could remain small. However. may not be worth the long-term costs. such as reductions in payroll taxes. Unfortunately. Holger S c h m i e d i n g : The Fading Miracle – Four Decades of Market Economy in Germany. A temporary income tax cut.FORUM the late 1980s ended in tears. By encouraging a better use of resources on trend. this pro-cyclical element then elicited a harsh Bundesbank response which helped to prepare the ground for the next cyclical downturn. Cambridge University Press 1992. And the rush to buy in late 2009 is unlikely to trigger any business investment response. The best tax cuts could also enhance the long-term incentives to work and invest. would be the best way to do so. such a tax reform would stimulate consumption as households adjust to improved long-term income expectations.2 The stimulus thus ended up being more pro-cyclical than anti-cyclical. Our favourite example are the payroll taxes in Germany and France. a determined cut in such taxes would thus raise the supply potential and income expectations in the economy. In theory. Incidentally.

Against that. The deficit may not shrink very much in 2010. the cut in payroll taxes. a hotchpotch of measures including an accelerated depreciation allowance for business investment. a bigger tax break for home repairs and the like. However. A joint European approach would likely be counterproductive. However. we have to add the first stimulus programme passed in December. A series of national initiatives. the most important task for European authorities is to get the monetary stimulus right. For the long-term growth prospects. Germany very much needs a better school system. the tail end of the stimulus could end up being partly pro-cyclical rather than counter-cyclical. for instance a big immediate cut in payroll taxes. an immediate stimulus to demand would have made most sense. 9 . This first package could provide up to €8 billion in fresh money for 2009. we have to set the long-term costs of higher public debt. As a result. the example of the biggest EU member state. Germany. followed by roughly €35 billion for 2010.2% of GDP. the case is still not very convincing. we also expect the bulk of the extra government spending to be used only in late 2009 and in 2010. the actual stimulus in the first half of 2009 will probably be negligible. probably with €3 billion for the second half of 2009 and €6 billion for 2010. Germany‘s total fiscal stimulus for 2009 could thus add up to around €30 billion. • Our experience with additional German public spending to combat recessions is that most of the money does little to enhance the long-term growth prospects of the country even if the spending comes under the label “investment”. and especially to repair the transmission mechanism of monetary policy through the banking system and financial markets so that the unusually low rates and the very generous injections of central bank liquidity could work. The resulting extra burdens on future generations could more than offset the very small positive impact on incentives and thus on long-term growth which some of the measures agreed upon may have. in our view. and (2) does is affect the long-term growth potential of the economy (supply)? The cuts in income and payroll taxes will kick in only on 1 July. As there is hardly any stimulus for the most crucial time period. This second German stimulus package is a very mixed batch. However. the package is also a very mixed batch: Intereconomics. But its structure (a cut in the starting rate of income tax from 15% to 14% and minor changes to the tax schedule) will not do very much to strengthen the incentive to work. • The additional cut in income taxes is also welcome. the Constitutional Court has re-instated a tax break for commuters. we need to ask two questions: (1) does it stimulate demand to dampen the recession. equivalent to 1. The verdict on such national programmes has to be taken on a case-by-case basis. The German programme highlights the risks that a fiscal stimulus could come too late to actually smooth the cycle much. However. this could put €7. to stop and reverse the current downward spiral in investment and business early. All in all. the total fiscal stimulus from this package that will be effective in 2009 will probably not surpass €12 billion with the impact backloaded rather than frontloaded. the fiscal boost may not kick in before monetary policy is also starting to work. in our view. But repairing some old school buildings faster than initially planned will do little to raise the quality of education. As a rough guess. subject to some EU safeguards against flagrant “beggar-thy-neighbour” attempts. cuts in income and payroll taxes (around €18 billion for the two years) and a number of smaller measures such as an increase in child allowance and a €2500 lump sum for replacing an old car with a new one. If the economy recovers in 2010. is also one of the smaller elements. the first half of 2009.FORUM gether). Including the re-imbursement of overpaid tax to commuters. Germany at least has not managed to use fiscal policy to fill the gap which the temporary impairment of monetary policy has created. Given Germany‘s cumbersome planning and disbursement procedures.5 billion into the hands of commuters this year. To judge it. For instance. We expect Germany to clearly breach the Maastricht 3% deficit limit in 2009. Summary The case for some fiscal stimulus in the European Union is stronger in the current downturn than usual. probably with a result around 4%. National approaches could make more sense. In addition. January/February 2009 • The one element that is clearly positive. does not inspire much confidence that the national fiscal programmes could be designed well enough to warrant their longterm fiscal costs. at least gives countries the chance to learn from each other.

the numbers for Intereconomics. In this sense Germany has positioned itself as a future low tax country within Europe (at least until the most recent stimulus package was decided). Sooner or later taxes will thus have to increase to the German level. As the fiscal plans are constantly changing. This convergence of view is global. compared to close to 50% in the euro area (and Germany). with interest rates apparently at historically low levels on most maturities most models indicate that fiscal policy should be particularly effective in stimulating demand since under the present circumstances higher deficits apparently no longer crowd out investment or other expenditure through higher interest rates. T ferent financial situation of Anglo-Saxon households. slightly higher than on average in the euro area. The remainder addresses these three issues in turn. This advantage has been completely lost in the case of the UK (in whose case one can use the 2009 projections from the Commission as the fiscal response to the financial crisis has been more on the revenue side (e. For the USA it is more difficult to get precise numbers. Belgium. Moreover.FORUM Daniel Gros* Convergence and Divergence in Public Finance he current crisis has led to an almost instantaneous convergence on the view that fiscal policy needs to be used vigorously to mitigate the impact of the financial crisis on the real economy. The deterioration is even more pronounced relative to Germany which over recent years has decisively cut back on public expenditure. However. the share of the government in GDP also indicates roughly the importance of the automatic stabilisers. The convergence in expenditure patterns will actually accelerate as the result of a shorter term divergence which concerns the response of fiscal policy to the financial crisis: fiscal deficits are increasing much more in the Anglo-Saxon world than on the continent. Moreover. The share of the government in the economy might thus increase on a longer term basis. Governments on all continents have recently announced large stabilisation packages. with little opposition from economic experts. Centre for European Policy Studies (CEPS). With this convergence in expenditure patterns automatic stabilisers have also become roughly similar on both sides of the Atlantic. about 4 percentage points below the UK value. giving the UK an advantage of more than 8 percentage points and the USA one of close to 14% of GDP. from slightly above the euro area value to around 44% of GDP today. Brussels. The key reason for this latter difference might lie in the dif* Director. the difference between Anglo-Saxon and (continental) European public finance has been changing gradually over the last decade as expenditure has trended upwards in the USA and the UK. whereas it has been under control in most of continental Europe. it might well be that it will be more difficult than currently anticipated to reduce government expenditure once the crisis is over. This implies that the UK has de facto to become a high tax country.g.2% of GDP. However. There are serious arguments for this sudden conversion to the view that the government must intervene to sustain demand: official (central bank) interest rates are rapidly nearing zero almost everywhere. Table 1 illustrates these trends allowing for a comparison of present expenditure patterns with those of about ten years ago (around the start of EMU). a closer look at the data suggests that there have been some important shifts in public finance that started well before the financial crisis became the dominant theme. Moreover. but the intention of the Obama administration seems to be to increase public expenditure massively. On this account the USA and the UK started ten years ago with a strong advantage as their expenditure ratios were below 40% of GDP. This sudden preference for an active fiscal policy is thus usually motivated by the need of the present exceptional circumstances. Anglo-Saxon public finance used to reflect the Reagan/Thatcher legacy of small government and low taxation. In this sense there has been convergence. VAT reduction in the UK)) and has been almost entirely lost in the case of the USA. Convergence of Expenditure Ratios A key indicator of the present and future tax pressure is the ratio of total public expenditure to GDP because all expenditure has sooner or later to be financed by taxation. In the UK general government expenditure is now at 47. It is thus likely that the USA will soon have a government that has about the same economic role in the economy as in Germany. January/February 2009 10 . implying that monetary policy might have become ineffective.

9 +2. this expenditure category cannot provide a sustained boost to the economy since one cannot stock these items for future use. This will be a challenge from both the economic and political point of view as growth is likely to remain weak under the combined influence of a weak housing and financial sector. mostly in the 4-5% range as growth goes from about 2. But the solvent German household is likely to add any additional income. again in both Anglo-Saxon countries (already decided in the UK. Here again the deterioration set in well before the current crisis: over the 5-year cycle 1997-01 the UK and the USA had a deficit about one full percentage point below that of the euro area.1 By contrast. thus even before the financial crisis hit the UK and the US economies particularly hard.0 8. this had already changed completely with both Anglo-Saxon countries running a deficit just below 3% of GDP. In 2007. S o u r c e s : *Ameco. Differences in the Financial Situation of Households and the Effectiveness of Fiscal Policy Many discussions about fiscal policy remain abstract and national “stimulus” plans are usually reported in terms of one headline figure. **Commission forecast of January 2009. Compared to the euro area the deterioration was thus equal to three percentage points of GDP – over a period during which the Anglo-Saxon economies were widely assumed to be performing much better. Divergence (in the Fiscal Policy Response to the Crisis) The deterioration in Anglo-Saxon finances is immediately apparent from the numbers for the deficits. What is the reason for this striking difference in the response of fiscal policy to the looming recession? 1 Currently it is expected that the deficit will increase even further in both the UK and the USA. to its already considerable savings. but the increase in overall demand it provokes.4 47. still to be formalised in the USA) this trend is set to continue over the next years.2 0. However. own estimates. However. two percentage points above the euro area value.2 2009 expected early 2009** 2. January/February 2009 . The key reason for the difference in the revealed preference of governments in terms of the use of fiscal policy is probably very simple: there are important differences in economic structures which make fiscal policy much more effective under the current circumstances in Anglo-Saxon countries. 2009/10 can be only rough estimates based on the published stimulus packages in different countries.8 (B) 2009/10 45 48 49 55 42 (C) Change (B)-(A) -2. As an aside one might note that this implies that deficits of this magnitude are clearly not sustainable.6 0.4 +0.2 Table 2 Fiscal Deficit in % of GDP (General Government) Average 1997/2001 Germany Euro area UK France USA 1.6 1. To put it succinctly: tax rebates and transfers can help the insolvent AngloSaxon household to maintain consumption.1 0.8 S o u r c e s : Ameco.3 +9.6 2.6 3. For 2009 the Anglo-Saxon deficits are now projected at around 9% of GDP and 2010 is anybody‘s guess.6 3.4 8-10 0.9 4.4 2007 2009 expected November* 0.8 5. which is known to be temporary.1 52.7 2. However. supposedly because of their more innovative financial markets. namely the increase in the budget deficit that is expected from them. It is widely expected that the recession will actually be somewhat shorter in the USA.5 7.FORUM Table 1 Total General Government Expenditure in % of GDP (A) Average 1997/2001 Germany Euro area UK France USA 47. Most predictions for 2009 imply currently that the loss of growth should be fairly uniform across Europe. a gap of five percentage points. The most direct way for governments to increase demand is to buy goods and services directly from the market. Given the large fiscal stimulus packages.5 +7. the deficit for the euro area can be expected to be closer to 4% of GDP. Governments spend about one fifth of GDP on consumption of goods and services.7 39. it is not widely recognised that it is difficult to obtain a large boost quickly in this way since most European governments spend very little this way. Predicted growth rates for the USA are somewhat higher for both 2009 and especially for 2010. the effectiveness of a stimulus plan should not be measured by the increase in the deficit.5 34. Table 3 documents this for the major expenditure items.8 5. This leaves public sector investment as 11 Intereconomics.8 2. At some point in the not so distant future the UK and the USA will thus have to undertake a massive fiscal retrenchement.5% to minus 2% almost everywhere.2 1.

5 17.4 1. Even in the USA. The actual impact of the recently enacted stimulus packages in Germany and elsewhere in Europe might thus be quite limited. However.0 2. one has to keep in mind that public sector investment represents only 2-2. Table 4 shows that in only two of the larger member countries are households on average net borrowers.2 2. The experiences of the USA and Japan point in a similar direction.6 10. January/February 2009 .8 20. Even if governments were able to increase public investment by 20% in one year this would result in a fiscal impulse of less than 0.3 21. Not surprisingly this is the case in Spain and the UK. fiscal policy will not be effective as households can just increase their lending in response to a tax cut. from 2. Concluding Remarks With the global economy in an unprecedented recession it is natural that attention is focused on the various fiscal stimulus packages enacted almost everywhere. if it wants to be effective immediately. which has the added advantage that higher public sector investment today should lead to higher productivity tomorrow. for households which do not depend on credit the situation is quite different.3 4.3 16. Households that are saving anyway will probably at present just increase their savings in response to an increase in their disposable income which they know to be temporary. which make up the bulk of the expenditure. one would expect that the over-indebted households in the USA and UK will react much more to similar measures. particularly in Germany) suggests that tax cuts and increases in transfers will have only a rather limited impact on private demand. How likely is this to happen? A key factor will be the financial position of households themselves: households that depend on credit to finance their consumption will be most affected by the credit crunch and are thus most likely to react to a tax cut by maintaining their consumption.6 2.5 19.7 12. which might be why this is also where the call for a fiscal stimulus started and where the deficits are now the highest. In these two countries (with 12 the largest housing bubbles) fiscal policy should thus be effective.6% of GDP (in 2009). work through transfers to the private sector. This contribution argues that there had already been some convergence in the share of the government between Anglo-Saxon and continental European countries even before the increases in public sector expenditure programmed now. households still choose to save a large part of the tax rebate implemented in the early summer of 2008.97 % of income 9 -5 5 5 -8 S o u r c e : Ameco.6 17. For this type of household a tax cut (or an increase in expenditure) will thus be an effective tool to prevent an even sharper drop in consumption. in the three other large member countries households are on average net savers. In Japan the government has been running very large deficits. The strong financial situation of households in most of continental Europe (and.5% of GDP. lower even than the “Anglo-Saxon” average. In reality fiscal policy must thus. Fiscal policy should thus be much more effective in the Anglo-Saxon world. However.4 17.5 3.6 to 3.0 Germany Spain France Italy UK Table 4 Net Lending of Households Euro billion + 144 .6 3. again.6 20.0 19.FORUM Table 3 Expenditure of General Government as % of GDP Final consumption Social transfers EU27 EU 15 Euro Area 16 United States Germany France Italy Spain UK 20.27 + 66 + 63 .6 23. Germany in particular stood out until recently as moving towards the lowest public expenditure share in GDP. where the private savings rate has been close to zero. but an increase in private savings has completely offset this. in Europe. leaving domestic demand flat for a decade. Intereconomics.0 20. the most often mentioned expenditure category. This implies that the effectiveness of fiscal policy will vary greatly across the EU. The key problem here is that under the present circumstances of extreme uncertainty households might just save any increase in their disposable income. either via lower taxes or via higher transfers to households. take often a decade or more to realise.0 16. In these countries. the USA and even China.3 15. In the USA public sector investment is expected to increase by about 40%.4 15. However.5% of GDP and is difficult to increase quickly since the large projects. By contrast.5 2.0 Investment 2.4 16. and in particular in Germany where households are net lenders to the tune of about 10% of their disposable incomes.

That is why the countries with the most restrictive labour markets usually have the most tightly regulated product markets. such barriers rarely operate in isolation. Rigidities in these areas are widely perceived to be the key to improving the economic performance of Europe. drawing on the example of the other countries. Governments with short horizons do not want to pay the political costs of these reforms. the experience accumulated over decades of reforms can be very helpful in finding ways to compensate the short-term losers of these reforms. However. A However. “They know what to do. marginal or radical. by carrying them out. Experience has shown that European public opinions often react to events occurring in other countries. with this exclusive concentration on fiscal policy Europe is missing a great opportunity in the current crisis. but do not know how to be re-elected afterwards”. Removing these rigidities is proving extremely difficult. The reason why many of these reforms have not been undertaken is clear: most of them meet with fierce political opposition from the start although some also pay in terms of public budgets. These times of “extraordinary politics” should be used to carry out some of the badly needed structural reforms that have kept down the performance of the European economy for so long. More spending today should aim at making politically feasible what without compensation and in ordinary times is not. there is a group benefiting from them and lobbying for their preservation. Structural reforms are mainly a matter of national governments and constituencies. A key element in many reforms concerns the labour market and associated social legislation. Yet by pursuing these reform efforts simultaneously. The fact of the matter is that measures such as these usually encounter strong political opposition. Italy. This means increasing public deficits in the short run while enhancing the long run structural performance of their economies and improving their position along the intertemporal public budget constraint. Sometimes these spillovers have worked in undesirable directions (as in the case of migration policies after the enlargement). to the tightening of migration policies. Economic research on the political economy of reforms and.FORUM Tito Boeri* Seizing the European Day s the financial crisis has mutated into a global recession the attention of policymakers has shifted from the financial sector to fiscal policy as a demand tool. governments would be able to strengthen their positions vis-à-vis national vot* Bocconi University and Fondazione Rodolfo Debenedetti. they are concerned that. What is more. they may not be re-elected. This analysis revealed that – contrary to common wisdom – many 13 Intereconomics. and not because governments do not wish to carry out reforms. ers and exploit yardstick competition. rather than trying to cheat with the numbers of stimulus packages that will always fail to be as sizeable as the current global recession would require. Governments will not be blamed for the unavoidable recession. to the increasing popularity of flexicurity arrangements. governments should concentrate their efforts on devising long-ranging reforms and buying consensus around them. the current recession is creating a TINA type situation: There Is No Alternative to carrying out reforms. Jean Claude Juncker. from fiscal discipline and social pacts associated with the convergence to euro. At the European level the Commission has called for coordinated action to stimulate demand and most member countries have by now enacted sizeable fiscal “stimulus” plans. they vary from country to country and their opponents also differ across nations. Milan. January/February 2009 . but for the way in which they prepared their countries for the aftermath of the crisis. Structural reforms have indeed a national dimension. the IMF and other multilateral organisations to counter the global recession. We had numerous examples of political spillovers in the recent history of the Union. European institutional “rigidities” – those barriers that keep markets from operating effectively – exist because. Reforms are categorised as either popular or unpopular. As stated by the European veteran. somewhere. above all. Now it is time to have them playing in favour of long-term growth. This effort does not require as much policy co-ordination as the fiscal stimulus packages proposed by the G20. they are initially unpopular while they pay in the long run. Rather than spreading resources across a variety of public expenditure programmes of dubious effectiveness. The Fondazione Rodolfo Debenedetti has now established an inventory of labour market and social policy reforms carried out in EU member countries during the 1986-2006 period. a regulation in one area calls for regulations in another area. but only in the long-run.

that is. a reform of the public pension system is structural if it is going to affect.92 0. These inconsistencies and the marginal nature of most reforms have significantly increased the complexity of the European institutional landscape. There is a higher probability of carrying out the key reforms.38 2 2 8 1 5 1 19 21% 21 0. addressing the broader design of existing systems rather than their minor features. those that are politically difficult and structural. when GDP was growing at more than 2 per cent per year.g. Thus. However the changes have often been marginal: 583 out 645 reforms. all future cohorts of pensioners. average number of reforms per year and country (Ex: 19 politically difficult reforms in periods of recession / 21 country-years of recession).10 54 7 53 3 58 1 176 6% 247 0. sooner or later. And these reforms are more likely under a recession (19 per cent of country-year observations) than during periods of strong growth (16 per cent).04 Total per column Of which structural (%) Number of country-years Reforms per country-years Structural reforms per country-years N o t e s : GDP growth: downturns imply g<1. We find frequently reforms undoing one another over a few years. adding more employment protection and reducing rewards from participation.FORUM Table 1 Labour and Social Policy Reforms and the Macroeconomic Environment (1986-2006. about 2. that is roughly 90 per cent of the regulatory changes were not structural reforms. And there is a huge number of different soft landing schemes to retirement. we have assisted a multiplication of contractual types. but few resulted in lasting structural improvement. Finally. Thus.12 1 2 1 5 9 22% 21 0. there were 272 politically difficult reforms. We counted almost 650 reforms. during downturns than during upturns.16 Politically Popular Reforms GDP growth Downturns Upturns of which of which recessions strong growth 6 2 6 1 9 24 13% 26 0. Upturns g>1. a structural reform of the employment protection legislation is one that does affect all types of contracts (e.15 25 8 160 11 57 11 272 11% 187 1. as they reduce the generosity of public pensions or non-employment benefits or make employment protection less strict (445 out of 645.19 43 10 221 15 85 13 387 10% 247 1. reforms can be split between those that are unpopular. This means that these regulatory changes were not comprehensive reforms. in fact. that is. In particular. but also 148 reforms doing the popular job of increasing generosity. Moreover.57 0. In particular. the population of working age. been carried out over the past two decades. This overrepresentation of marginal reforms among the unpopular regulatory changes is a clear indication of the fierce political opposition that these reforms face. the message has so far been mixed: many reforms have been undertaken. the view that negative or slow growth prevents difficult reforms does not find support from this Intereconomics. EU15 less Luxembourg) Politically Difficult Reforms GDP growth Downturns Upturns of which of which recessions strong growth Employment Protection Legislation Non-Employment Benefits Public Pensions marginal structural marginal structural marginal structural 6 2 26 5 16 3 58 17% 26 2. reforms have. it should also concern workers under permanent contracts and not only those with fixedterm contracts). Pension rules are getting different from cohort to cohort. January/February 2009 .45 0. strong growth g≥2.2 per year and country. A reform of non-employment benefits is structural insofar as it affects the entire population at risk. with a number of fixed-term and unstable jobs going 14 hand in hand with permanent and still heavily protected positions. In the field of employment protection.90 0. for instance. In brackets. Can Europe do better now that a deep recession is unavoidable? An important message of this inventory (see also Table 1) is that during recessions or at times of economic stagnation it is actually easier to carry out these “politically difficult” reforms than proceeding the other way round.43 0. All this has increased the dualism of European labour markets.79 0.04 47 6 45 1 48 1 148 5% 187 0. that is. about 70 per cent) and those moving in the opposite direction.23 0. making them more segmented not only between insiders and outsiders but also among various types of outsiders.71 0.

Fiscal Policy as the Generic Solution to Sustain Demand? Taking the dire outlook as a starting-point. Te r r o n e s : What Happens During Recessions. of overdue corrections in housing markets. in some countries. it will be a rather minor economic reward. Overall. European supranational authorities can support this process by increasing yardstick competition. the IMF has come out in favour of an increase in direct government expenditure and against general tax cuts.html. after an evening of heavy-handed negotiations. politicians and economists are pondering about what could be done to keep the real economy from collapsing and to stabilise it. from the reduced costs of servicing the public debt of governments who succeed in convincing markets that they have indeed improved the long-term growth prospects of their economy. 2 * University of Duisburg-Essen and IZA Bonn. This is the consequence of a severe contraction of world trade and manufacturing output and. which made firms postpone hiring decisions and investment. As some forecasters are already expecting an upturn in the second quarter of 2009. Obviously. They can also reward those countries that carry out structural reforms through the allocation of the globalisation fund. Even Germany has acted. S. we check whether the option value of waiting in times of uncertainty is a good guideline for macro policies in times of crisis.8 per cent in 2009 before recovering moderately by 0. January 2009. Cf. Intereconomics. Washington 2008. not only in the USA and the UK. according to all indicators of the financial fear factor. E.0. Germany‘s stimulus is likely to be mostly pro-cyclical. M.com/article. Crunches and Busts?. the global policy response 1 European Commission: Interim Forecast. since monetary policy with its main interest rates approaching zero will no longer be effective. but especially in euro area member countries like Ireland and Germany. recent European history suggests that it is precisely now that European governments should act.581+M5151 93432ba. Fiscal policy seems particularly appropriate since our macroeconomic models tell us that fiscal policy multipliers increase when more economic agents become liquidity constrained because they are then likely to spend any additional income they receive. It is true that radical and unpopular reforms are difficult when unemployment rises and there is a strong demand for protection. a closer look at what fiscal policy can actually achieve suggests that one should be very cautious in expecting too much from this policy instrument. IMF Working Paper 08/274. According to the most recent interim report by the EU Commission.5 per cent in 2010. In the meantime. The main driver of the current economic weakness is uncertainty.1 Policymakers in the EU member states are currently shaping rescue packages to mitigate the impact of the crisis on their economies. A. The largest economic rewards from carrying out structural reforms will come. Given the limited size of this fund. However. It is mainly a matter of national decision-making. Uncertainty and Economic Crisis Is the Option of Waiting Valuable? I t is clear by now that the financial crisis has become a crisis of the real economy. but may involve a significant political dividend for the beneficiary. Ansgar Belke* Fiscal Stimulus Packages. but it is precisely under these conditions that one can find support for such difficult things as reforming public pensions and reducing the dualism of labour markets. Brussels. The generic answer which has constantly been brought forth since the collapse of Lehman Brothers seems to be to use fiscal policy to sustain demand. DG for Economic and Financial Affairs.3 However. with the German coalition government recently agreeing on a substantial stimulus package. C l a e s s e n s .2 We shall first discuss whether fiscal policy is the generic solution to sustain demand in the current crisis and highlight the potential benefits of fiscal policy cooperation in the euro area. January/February 2009 15 .eurointelligence. economic and financial uncertainty is now decreasing. in any event. A tentative explanation for this rather surprising result is that there may be a stronger perception of emergency when macroeconomic conditions are less favourable – recessions are often times of “extraordinary politics” – than during upturns when lobbies are at work to appropriate a larger share of the economic “pie”. M.FORUM dataset. K o s e . GDP in the EU is expected to fall by 1. Following that. For details see http://www. Germany.

N. Vol. N o r d h a u s : The Political Business Cycle. as in the current situation. http://www. these proposals did not become more appropriate the more they were contended with increasing frequency and vehemence. M. thus.5 Moreover. 5 8 9 A. G o e c k e : Real Options Effects on Employment: Does Exchange Rate Uncertainty Matter for Aggregation?. B l o o m : The Impact of Uncertainty Shocks. For an introduction into the second aspect cf. this is not a foregone conclusion if one accepts that fiscal policy can also be a source of shocks. No. Each government seems to be responding to the emerging problems with a country-specific set of measures. 6 Cf. H.. G r o s : On the Benefits of Fiscal Policy Coordination in a Currency Union: A Note.. 2009. 42. For a survey on the first issue cf. M. Our main result is that in general it might be better to have independent national fiscal policies that are not coordinated (or at least not correlated) under EMU. The argument that independent national fiscal policies are preferable because of risk diversification is not new and was already documented in the risk sharing literature by Sørensen. in: Empirica. 4 parts with partly higher debt burdens and often higher fiscal deficits. MA. would coordinated action at the European level be a better approach? Or can actions by national governments be expected to deal more adequately with the problems facing the national economy than a pan-European set of measures? The Merkel government in Germany has even been accused by some of displaying free-rider behaviour in the area of fiscal policy since it was more reluctant to push forward large fiscal rescue packages in the fight against the crisis than its euro area counter3 Cf. N. U h l i g : What Are the Effects of Fiscal Policy Shocks?. in: German Economic Review. Instead. January/February 2009 . T h y g e s e n : European Monetary Integration. Yosha. Given the global nature of the crisis. More fiscal policy coordination is also likely to lead to more correlated 7 Cf. 36/1. 6th ed. The Case of a Liquidity Trap Policymakers in the EU member states are currently shaping rescue packages to prevent the financial crisis hitting their economies with unmitigated force. and appeared less prone to European coordinated efforts.4 Hopefully. New York 1998. fiscal policy proposals by German political parties ahead of the super-election year 2009 varied from deficit-financed spending increases. and G.g.8 It is thus assumed that fiscal policy represents a source of shocks.D. A. Oxford University Press. 2009. pp. in: NBER Working Paper. Is this negative assessment justified? It is widely assumed that a common currency makes it desirable also to have a common fiscal policy (and some even go as far as saying that the euro needs to be backed up by a political union). the lower the covariance among the individual components. for instance. B l o e m . European Commission. The often emphasised multiplier effect of additional government spending or of temporary tax cuts is often hardly larger than one. pp. the stabilising impacts of fiscal policy in general are often largely overestimated. because this leads to risk diversification: the variance of a sum of shocks is lower. cit. 2005. W. pp. 1975. Stanford 2008. Berlin-Heidelberg 2001.6 However. Cambridge. Addison Wesley Longman. However. There are a variety of reasons why fiscal policy could be destabilising in the context of the current crisis: policymakers do not have full control over the outcome. Springer. The key question then is whether a higher correlation of these shocks (presumably because of tighter cooperation) is desirable. the potential benefits of fiscal policy coordination in the euro area will be addressed in the following. D. P. Finally.org/ index. B e l k e . 185-203. However. and N. political uncertainty has diminished as many world leaders have clarified the details of their stimulus packages.FORUM to the financial and economic crisis has calmed stock markets “as the fears of an economic Armageddon have subsided”. 12 January 2009. The simple model used by Belke and Gros9 which was designed for “normal” economic periods serves to illustrate a general idea which should hold up in more sophisticated models as well. van Wincoop and many others. Vol. op.10 Our analytical results suggest that the often repeated calls for fiscal policy coordination in ordinary times might be misguided. 14551. 16 Intereconomics. the latter is not always the case.voxeu. 169-190. the economic forecasts underlying fiscal policy might turn out to be wrong. They report that the key measures of uncertainty have dropped so rapidly that they believe growth will resume by mid-2009. Also. in: VoxEU. F l o e t o t t o : The recession will be over sooner than you think. A. D e G r a u w e : Economics of Monetary Union. D. in: Review of Economic Studies. or. G r o s .7 However. B e l k e . and at times the effect of a certain measure (e. Vol. forthcoming in: Econometrica. the long-forgotten political expenditure cycle of the Nordhaus-type appeared to be back on stage again. a tax reform) is quite different from what is anticipated. M o u n t f o r d . the large difference between temporary and permanent fiscal shocks means that for the effectiveness of the fiscal policy measures it is of crucial importance that measures are not believed permanent by private agents. Oxford 2005. the economic medicine has not been administered just as the patient is striving to leave the hospital! Depending on their ideological couleur. 45-49. G a n d o l f o : International Finance and Open-economy Macroeconomics. 2008. in order to avoid a too Germano-centric perspective. balanced budget spending increases (financed with higher taxes) to deficit financed tax cuts until the turn-of-year 2008/09.php?q=node/2785. 6.

also the expenditure part of the recent German stimulus package is not backed by the Mountford and Uhlig study. in: Journal of International Economics. for instance. the economic agents are hoarding their cash. 45. and B. J. SPN/08/01. the fiscal stimulus initiated by the euro area countries is sub-optimally low. 11 spending increase. Vol. lower interest rates. Although the best fiscal policy for stimulating the economy appears to be deficit-financed tax cuts.banque-france. 1081-1110. However. However. Washington. there is no a priori argument – at least from the German perspective – that fiscal policy is needed because monetary policy is helpless. Efficacy of Fiscal Policy Mountford and Uhlig. 2008. O. are credit constrained but the latter already pay little in the way of taxes. they impressively point out that this should not be read as endorsing them. income dependent) components of fiscal policies in a monetary union.e. particularly the UK and Spain. With interest rates converging to zero. the spillovers of fiscal policy are of course positive because the interest rate does not react. competition between different theoretical models or 13 A. The recent interest cuts by the ECB have de facto lowered the returns of government bonds rather well. it thus appears that Germany’s Finance Minister Mr. Steinbrück was not too mistaken with his long-lasting reluctance vis-à-vis the demands for extensive deficit spending earlier in 2007/2008. the German economy.14 Some also doubt that the results obtained by Mountford and Uhlig can be transferred on a one-to-one basis to exceptional situations like the current crisis. who formally disentangle the discretionary component from the endogenous (i. one developed by Belke and Gros. Yo s h a : Channels of Interstate Risk-sharing: US 1963-1990. P. Daniel Gros shows in his contribution in this volume that this kind of argument is applicable only to a few EU countries. A s d r u b a l i . in: Quarterly Journal of Economics. international institutions like the IMF speak out against general tax cuts and in favour of an increase in direct government expenditures. E. But of what type? Model Uncertainty and Forecast Uncertainty Issing. Taken on the whole. D. for instance. in which many consumers.11 However. P e r o t t i : Fiscal Policy. a balanced budget spending increase (financed with higher taxes) and a deficit financed tax cut. S ø r e n s e n . DC. not that they are sensible. Paris. S p i l i m b e r g o . This result even holds if it is backed by a more complicated variant of the model used here. S. there are other studies available. have analysed three types of policy scenarios: a deficit-financed 10 Cf.15 for instance. in: International Monetary Fund. with the notion of a liquidity trap John Maynard Keynes described a scenario in which an increasing money supply is unable to lower bond yields. the option to conduct them later on) can also be valuable simply due to the existence of uncertainty. Is the government unable to do otherwise by enacting counter-cyclical fiscal policy measures? It is well-known that. pp. 1996. They are created by. from the more common to the more complex and “Knightian” ones. acknowledges that the uncertainty factors faced by those responsible for macroeconomic policy are myriad and interdependent. is ineffective in this precarious situation. 2008 . Staff Position Note. C o t t a r e l l i : Fiscal Policy for the Crisis. Wealth Effects. Vol. However. R. January/February 2009 17 . Hence. this way of reasoning decisively hinges on the existence and significance of a liquidity trap in the euro area economies. No. in the case of the current economic crisis it is reasonable to proceed on the assumption that an exogenous shock to demand has hit the euro area countries significantly. op. this conclusion is supported by our simple model structure and holds primarily as long as no other large shocks emerge..13 In sum. Monetary policy. O. Cambridge. actual data do not corroborate this view. some of them claiming that fiscal policy is more effective since private consumption is stimulated via a “crowding in” effect. B e l k e . M o n a c e l l i . distinguishing three broad categories of uncertainty. Fearfully. 29 December 2008. pp. 15 O. Also. the existence of a liquidity trap cannot be taken for granted. G r o s : Is a Unified Macroeconomic Policy Necessarily Better for a Common Currency Area?. Yo s h a : International Risk Sharing and European Monetary Unification. I s s i n g : Monetary Policy in a World of Uncertainty. of course.FORUM fiscal policy shocks and this might increase actual output variability. and Markups. They only point out that unanticipated deficit-financed tax cuts work as a (short-lived) stimulus to the economy. A. C. As the saying goes. in: Fondation Banque de France Centre d’Etudes Prospectives et d’Informations Internationales CEPII Université Aix-Marseille IDE. B. forthcoming in: European Journal of Political Economy. However. B l a n c h a r d . O. In case of the latter. cit. 211-238. H. Accordingly. for instance. 14584.e. i.pdf). As always.MA. in which revenues decrease but government spending stays unchanged. the current yield of outstanding German government bonds has fallen to historical lows. Hence it is argued that it is plausible to assume that firms and consumers will use tax cuts first of all to clear up their balance sheet.fr/gb/fondatio/telechar/issing.144. this negative shock has significant external effects which should ideally be internalised by a coordinated effort of national fiscal policies. 12 Intereconomics. is currently on the ropes of a liquidity trap. Hence. 9 December 2002 (http://www. A. U h l i g . in: NBER Working Paper. M o u n t f o r d . 14 T.12 for instance. S ø r e n s e n . 1998. But waiting with fiscal stimulus packages (with. above all in the USA. However. S y m a n s k y. in the Nash equilibrium.

Thus. However. to gain more evidence about the effects of the already initiated steps and of the automatic stabilisers for the time being. http://www. 19-46. although these programmes might be needed even more pressingly. A. It is already likely that Germany’s new borrowing in 2009 will not be below the Maastricht level. Until today.vanderbilt. the promise of an all-embracing tax reform after the federal elections will probably not be kept. January/February 2009 . B r u n n e r.17 Especially in times of great uncertainty it thus makes sense to wait somewhat with the implementation of expansionary policy measures such as tax cuts and expenditure programmes until the fog of the forecast uncertainty has lifted and it has become clear how large the economic crash really is. the German Grand Coalition was well advised until the end-of-year 2008 to keep its powder dry for the crisis year 2009. 1976. at least temporarily. While some “only” come up with a contraction of 0. German government debt is heavily increasing these days. The German government therefore should now provide for a quick (basic law) statutory anchored debt brake in the federalism reform II. 16 Even Higher Debt Levels after Fiscal Package Deals Each tax cut included in the stimulus package II lowers the leeway for future tax reforms. the question that had it stumped. A great bulk of the aforementioned macroeconomic models cannot be applied under the current circumstances and business cycle forecasts are currently afflicted with a still rather high degree of uncertainty. it is not clear how credible this is. This still allowed the option to act quickly as the crisis and the awareness thereof became even more intense. Kenneth R o g o f f at the AEA 2009 Meeting. education and family issues. the most effective prerequisite of future tax cuts is Germany’s strict compliance with the Maastricht criteria. However. in: Journal of Monetary Economics(Suppl. The Option Value of Waiting It has increasingly been argued in recent weeks that. Some analysts fail to appreciate that the appropriate macroeconomic models are currently suitable neither for forecasting nor for evaluating policy measures. M e l t z e r (eds. it had to be determined how the expected large budget deficits were to be compensated by additional government savings after overcoming the crisis.edu/AEA/Annual_Meeting/ index. If the pessimists among 17 Cf.): The Phillips Curve and Labour Markets. enacting large economic stimulus packages is justified since governments should at least try to stabilise the economy. In order to avoid becoming an amplifier of the crisis itself. Hence. L u c a s : Econometric policy evaluation: A critique. The latter type of model uncertainty has gained a new dimension in the wake of the current crisis. Anyway.5 per cent. A prototype example of the immense future costs of self-defeating deficit financed fiscal packages is Japan. follow the Knightian approach to uncertainty and rely more than usual upon qualitative analyses. The German government therefore deserves support for its approach up until 12 January. pp. Even worse. However. future additional programmes become even more expensive because the level of public debt will then be higher. At present. since tax cuts cannot be planned without an eye on government debt. They contain a good deal of speculation and cannot serve as a sound quantitative basis for the adequate dosage of counter-cyclical fiscal policy packages. in spite of all imponderabilities. model based policy consulting by and large does not appear to be able to answer the question of how to fight the fallout of the crisis.htm. with an eye on the option value of waiting. However. 18 Intereconomics. research. the only reliable fact is that aggregate demand still appears to be weak. None of the relevant macro models had foreseen and predicted the financial crisis of 2007/08. inter alia because this kind of model does not contain the currently decisive variables such as venturesomeness and credit growth.). H. in: K. If such measures are enacted today. The estimations of German growth are all within the negative spectrum. others no longer exclude a minus four.FORUM structural change. R. this argument is not completely consistent. This is due not least to the vagueness of the extent and the effects of the worldwide reactions of economic policy to the crisis. in extreme times like the present business cycle forecasts are not of much help. their range has been unusually high. this wait-and-see attitude has not precluded working on plans for a contingency budget („Eventualhaushalt“) with longer term expenditure programmes in the areas of infrastructure. at the very least it could do no damage. for instance in the shape of deficit financed tax reductions. And in reality. E. American Economic Association. 2009. However. Starting from this background it is either a remarkable irony of history or a clear but probably unintended case in favour of the Lucas critique16 that those institutions which still forecast a deep enduring international crisis are those which demand fiscal stimulus packages the most pressingly and see them going into effect by now. a government should. Proceedings of the Annual AEA Meeting in San Francisco. where the different fiscal policy measures in the 1990s have led to a massive increase in public debt which will continue to burden Japanese citizens for decades and which makes current fiscal policy measures much too expensive in terms of costs of repayment.

though on its way down. amid the uncertainty over the size of the real effects of the financial crisis. 7 Januar 2009. from the perspective of the option value of waiting under uncertainty and assuming that uncertainty was still high and the package was not large and effective enough. the German government would be in need of it. 2009. low empirical realisations lets one expect a further stock market performance without strong price fluctuations. in: New York Times. Investment. Opinion. Future uncertainty does not enter the decision under risk neutrality. A. Finally. High empirical realisations point to a still restless and irregular market. M. 1-2. and Deutsches Institut für Wirtschaftsforschung: Wochenbericht. which still matters up to now (Figure 1). Belke 19 20 S o u r c e : Thomson Financial Datastream. Assessing expectations of average citizens in Main Street through the use of keywords in main newspapers indicates a modest decline of uncertainty since October 2008. Intereconomics. Te r r o n e s . the likelihood that investment will be postponed to the end of that period depends only on the uncertainty during that period and not on future uncertainty. January/February 2009 19 . 21 P. http://www. This simple model view abstracts from risk aversion. Hence.FORUM Figure 1 “Barometer of Fear”: the DAX Volatility Index (VDAX) 2007-2009 high.org/index. However.19 This is even true with respect to the frequency of the use of the expression “uncertain” in the press. J. this view is misguided since already in 2009 an estimated budget deficit beyond the Maastricht limit of three per cent is not impossible. M. E. Vol. a closer look at the economic effects of uncertainty suggests that this might be a poor strategy around the turn-of-the-year 2008/09 – especially because uncertainty in the markets is still extraordinarily 18 Cf. 23 December 2008. K o s e . In the case of Germany. indicators of financial fears are not reliable early business cycle indicators. One important implication of the model of the option value of waiting is that only the current short-term uncertainty has an impact on the decision to wait. C o h e n : Uncertainty and the credit crisis. M. This implies that even short spikes in uncertainty can have a strong impact on investment. S. op. Cf. The arguments for a further cut in interest rates and a large fiscal stimulus seem compelling: inflation is now clearly below the ceiling set by the ECB itself and demand is so weak that there is no danger of fiscal policy induced pressure on prices emerging in the near future. N. in: VoxEU. 76. some argue that especially for Germany there is ample room for fiscal manoeuvre. strong and durable impact on economic activity. M. for instance one year. it appears definitely too early to argue that (a) Germany has recently shifted to a less pronounced uncertainty regime since all actors have become aware of the potentially huge dimensions of the crisis and (b) one should have agreed only three months ago with analysts like Paul Krugman21 who warned that a dire recession was brewing. The VDAX jumped over fourfold after the dramatic collapse of Lehman’s in September 2008. the forecasters at that time were to be believed. K r u g m a n : Ideas for Obama. cit. No.. Consumption and Uncertainty Pressure on the European governments to increase spending or to cut taxes is growing as mid-term growth prospects for the euro area worsen. The actual figures reveal a positive structural break in the data since 25 August 2008. the German government killed its option too early on 12 January 2009. the VDAX is frequently called the “barometer of fear”. Berlin. F l o e t o t t o . B l o e m . op. claim that uncertainty shocks have a swift. the euro area economy is arguably in need of some stabilisation. But how large is uncertainty at the moment really? How Large is Uncertainty at the Turn-of-the-year 2008/09? However. But it has fallen back by 50 per cent over the last couple of weeks as both economic and political uncertainty has receded. in the same way as business cycle forecasts are currently afflicted with a continuingly high degree of uncertainty. cit. C l a e s s e n s . Moreover.voxeu. php?q=node/2732. Hence. 11 January 2009.18 Hence. A l e x o p o u l o s . Alternative measures of uncertainty such as the implied volatility on the S&P 100 which is commonly known as the financial “fear factor” have also fallen. suggesting that “the worst may be behind us”. If one takes a fixed period. However. the relevant type of financial and economic uncertainty is traded via the VDAX which delivers the implicit 45 day-ahead volatility of German stock futures (DAX) in per cent.20 However.

among others Dixit and Pindyck. pp. However. there are always some political constraints: it tends to be much easier for governments to ease fiscal policy than to tighten it. The temptation to postpone investment decisions is particularly strong when the uncertainty is likely to be resolved in the near future (as. 2001. Ibid. New York 1964. at least according to many scholars. from which it has never been properly separated … It will appear that a measurable uncertainty. Harcourt. cannot eliminate indeterminateness from the future. Why are we talking about “Knightian uncertainty”? Because Keynes is back. In the end. Hence. S. In his seminal work “The General Theory of Employment. Springer. the fiscal policy measures can rarely be adjusted to the changing economic circumstances. Knight insisted. Mimeo. in: Open Economies Review. A. 3. R. P o l l e i t : Monetary Economics of Global Financial Markets. New York 1936. Brace. 27 Cf. Knight argues that the difficulty of the forecasting process extends far beyond the impossibility of applying mathematical propositions to forecasting the future. D i x i t . 26 J. Cf.” Knight speaks of no less than the failure of the concept of probability calculus.FORUM and Gros22 show that the basic conclusion that even a temporary increase in uncertainty can make a postponement of investment optimal is robust to the introduction of risk-adjusted discount factors. On the other hand it has become increasingly clear in recent weeks that the bad realisation becomes more and more probable and the increasing deviation from the fifty-fifty probability assessment diminishes the “play area“.28 As a result. it takes time to pass the fiscal measures through the national Parliaments and for the economy to respond. 28 Cf. for instance. G r o s : Real Impacts of Intra-European Exchange Rate Variability: A Case for EMU?. This has confirmed that it is still tremendous.23 This formalises a common-sense rule: if a decision involves some sunk costs. or “risk” proper … is so far different from an unmeasurable one that it is not in effect an uncertainty at all. from the perspective of political economy a reversal is not cred25 Cf. it seems legitimate to argue that one disposes of a high uncertainty threshold to trigger on the option argument. January/February 2009 . Interest and Money”. T.24 has made tremendous progress in analysing risk and uncertainty in well-defined stochastic 22 economies. Uncertainty and Profit”. or some other element of irreversibility. 231-264. First. Princeton. M. A. While the academic profession. we have shed much more light on this issue in Figure 1 by means of a look at the current prices at which financial uncertainty is traded these days. New York 1994. Equally. K n i g h t : Risk. F. B e l k e . or any other element of irreversibility. A. economists have developed the concept of the “option value of waiting under uncertainty”. 12. the “Knightian uncertainty” that confronts monetary policy and sometimes markets is of an altogether different dimension. once decided. Century Press. forthcoming 2009. it makes sense to wait until the uncertainty has been resolved. evidence of an “option value of waiting” for monetary and fiscal policy should emerge since we still find ourselves in a period of extraordinary uncertainty. P i n d y c k : Investment under Uncertainty. It was US economist Frank Knight (1885 – 1972) who. A priori reasoning. Vol. 2001. K e y n e s : The General Theory of Employment. M. B e l k e . This means that the two effects currently run against each other and the net effect is not clear yet. in his book “Risk. Skeptics towards this approach might argue that there are two effects working in the opposite direction which are relevant in the current situation. No. and the sense and nonsense of counter-cyclical fiscal packages in times of uncertainty have to be discussed from the Keynesian perspective as well. B u t i : The Economic Downturn and Budgetary Policy in Europe. Uncertainty and Profit. On the one hand.” In fact. by fiscal packages!) This conclusion appears to be independent of the assessment of uncertainty as a stochastic or a Knightian phenomenon.27 This assessment fits extremely well with the current situation and would a fortiori lead to the same assessment of the (non-) usefulness of macro stimulus packages of a magnitude below a certain threshold in the current crisis according to the concept of the option value of waiting under uncertainty. Interest and Money. D. 23 24 20 Intereconomics. To deal with the influence of uncertainty on economic decisions. 1921. Second. he considered reliance on the frequency of past occurrences extremely hazardous. there is a still extraordinarily high economic and financial uncertainty which increases the “play” area of weak reaction by macroeconomic variables to changes in macroeconomic policy. “Option Value of Waiting” for the Government It is clear that any decision to increase government spending and/or to lower taxes involves some sunk costs. John Maynard Keynes (1883-1946) takes a very similar stance:26 “[Most of our decisions] to do something positive … can only be taken as a result of animal spirit … and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. built his analysis on the distinction between risk and uncertainty:25 “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk.

for instance the government shocks “today”. it would still have the option to proceed if that was to its advantage. This uncertainty is likely to be completely resolved in the medium run. pp. uncertainty which cannot be hedged raises the variability of revenues and induces the investors to apply a higher discount rate on (expected) future revenues. And the ongoing weakness of the stock markets will almost certainly not quicken Germany’s political pace towards a stronger adoption of private pension schemes. Hence. Once the uncertainty had been resolved. the option value of waiting in times of uncertainty is not limited to the government but also extends to private agents. perhaps not in a matter of months. many apparently unrelated decisions. it kills the option to shock in the future (although this option might be very valuable in times of high uncertainty). Vol. i. Fiscal policy shocks are not effective if uncertainty is large. in: Journal of Political Economy. 3. A deep recession which has the potential to turn into a depression may be averted. The same assumption is used also by A. a balanced budget spending increase (financed with higher taxes) and a deficit financed tax cut in times of large financial and economic uncertainty? A first argument against this approach would be that the concept of the „option value of waiting“ applies to a government just as much as it applies to everyone else. O r t h .in order to avoid blowing up the next asset price bubble. In the context of the financial crisis of 2007/08 and the potential 2009 depression. it risks having to reverse its decision almost immediately if the crisis turns out to be relatively short-lived or – if financed by inflation . A. for instance.29 At the start of the financial (subprime) crisis it was argued that it would not have any appreciable direct consequences for the European economy since Europe. but certainly in a matter of one or two years. as some analysts maintain. or it may be relatively short and have little durable effect on important macroeconomic variables such as the labour market. January/February 2009 21 . A third important aspect is the following. Intereconomics. pp. G r o s .e. According to some other simple models. S e t z e r : Sowing the Seeds of the Subprime Crisis – Does Global Liquidity Matter for Housing and other Asset Prices?. Hence. one would expect demand – especially investment demand – to remain quite weak in the near future. in: International Economics and Economic Policy. consolidation will not be a pleasant enterprise since Germany will have to cope with the economic consequences of demographic change.) so that decisions can be based only on expected values. However. 5. a durable consumer good in times of high uncertainty (of being employed at all in the near future. Anyway. will have consolidated its debt no earlier than sometime around 2020. the process of debt accumulation by expenditure programmes is most probably asymmetric and. B e l k e . R. 1989. having significantly extended its trade with emerging markets.30 The government should thus trigger a positive fiscal policy shock only if it is convinced that such a shock will make sense even if the uncertainty about the length and the duration of the crisis is favourably resolved. No. 30 A. This explains why the financial crisis weighs so heavily on 29 For simplicity. and loss-making if not. This uncertainty makes it worthwhile to postpone consumption and to wait for even lower prices). D i x i t : Entry and Exit Decisions under Uncertainty. A long and deep recession cannot be excluded a priori. D. op. discounting issues and risk aversion are ignored here (on this cf. “Option Value of Waiting” for the Fiscal Authority – a Deeper Analysis So should a government then not try to stimulate demand with a fiscal shock. Such a business would lose little (in terms of forgone profits) if it delayed the decision. Vol.FORUM ible. cit.e. while it remains. can be regarded as at least partly irreversible. If. thus. 97. or if it led to a disruption of the banking sector and some branches like the car industry. the package is package-deal specific and once the measure is taken it tends to become irreversible. as time went by it was recognised that the indirect effects could be substantial if the crisis lasted longer than expected. 620-638. if the government triggers another fiscal policy shock within the coming months. 403-424. However. 2. B e l k e . i. Germany as it stands now. 2001. after having decided on the second fiscal package. However. a fiscal policy shock as an insurance against a bad outcome does not make sense since: 1. An analogous argument applies to the consumers who might delay their decisions to buy. had probably de-coupled from the USA in terms of the business cycle. even more profitable if the uncertainty were favourably resolved. as for instance a deficit-financed spending increase. The government itself disposes of an option value of waiting with fiscal policy shocks. which tends to aggravate the current weakness of investment and consumer goods demand. to wider regional financial and economic instability. 4. “Option Value of Waiting” for Private Agents You can imagine businesses assessing investment projects that would be slightly profitable under current circumstances. W. 2008. Frequent fiscal policy changes by a government induce additional uncertainty.

“Klotzen nicht Kleckern”: if you are going to hit it. because that would not be a sensible compromise in times of still high uncertainty. Moreover. F a t á s . the above analysis has a clear bearing on the current discussion about the crisis management of the world’s leading fiscal authorities with respect to the US-driven financial and economic crisis. common sense tells us that acting according to the motto “It’s now or never for expansionary policy” is not really an option. in fact. Dithering over different directions of policy might actually make things worse by adding uncertainty. real options theory teaches us that.33 However. great uncertainty also generates an option value of waiting for the fiscal authorities. uncertainties probably affect decision-making in Europe more than they do in the USA. F. B e g g . The above analysis has shown that the specific way out should depend on the magnitude of the planned package. As the Germans say. The latter are especially important in continental Europe (although Germany has made some progress in lowering labour market rigidities in recent years due to the Hartz reforms). on the estimated degree of uncertainty prevailing and on the credibility of later consolidation. one could make the case for a stronger fiscal policy response. 22 Intereconomics. simply because it might be too late for such a large stimulus. in times of high uncertainty about the risks finally faced by firms. January/February 2009 . MIT. And. The government is just painfully caught between the conflicting alternatives “to react quickly” or “to wait with fiscal stimuli”. real world investment. American Economic Association. P. Abstracting from real option theory under uncertainty. Any additional economic stimulus has to be implemented quickly. just as little as a cut in central bank interest rates is useful for this purpose.31 Thus. cit. it should avoid shocking a little today. given the still 31 prevalent structural rigidities in the euro area economy. for instance the increasingly apparent debt problems in the euro area suggest that the government should stay its hand. at least in Europe. P. Instead. a cut in taxes or an increase in expenditures as an insurance against a bad outcome does not make sense. However. Firms will probably begin to hire and invest again to make up for lost waiting time. growth should start to rebound and a large stimulus will no longer be needed. L a n e : Surviving the Slowdown. There is always a band of inaction – a price range within which it does not pay to change course. starting with the above-mentioned irreversibilities which are specific to fiscal policy. Instead. Hence. The size of this band of inaction increases as uncertainty increases. D. 2009. mimeo. which is so urgently needed to prevent a world recession. Newspapers worldwide reported in the wake of the AEA Meeting that many US economists interpreted a large but arguably transitory increase in direct government expenditures as the most important insurance against a “Great Depression II”. The Band of Inaction The models of decision-making under uncertainty also have a second implication. Due to the extraordinarily high degree of uncertainty. it does not induce more than a straw fire on the stock markets and the entire economy for several days but certainly does not induce a sustainable move towards more investment and consumption demand. All decisions involve some transaction costs – whether they concern investment. For a general discussion of interest rate decisions in an uncertain environment cf. R. one should advise against a large stimulus anyway – mainly with an eye on too high and unsustainable debt levels. That might be correct in principle. London 2002. But if the government is not convinced of this. C a n o v a .32 Applying this argument to continental Europe is certainly not admissible. one should not be trapped in the currently quite popular fallacy that Keynesian demand stimulation will be successful in Europe only because it appears to work in the USA. A. abstaining from over-expansionary fiscal policies in interplay with monetary policy which inflates the economy in order to push down real debt avoids sowing the seeds of the next asset price bubble and the subsequent crisis. or bureaucratic sclerosis in general. but policymakers would need to (re-)act fast. Centre for Economic Policy Research (CEPR). The pleas of the majority of speakers at this year’s AEA Conference 2009 in San Francisco in favour of significant increases in government expenditure do not appear to be in contradiction to this assessment because they almost exclusively refer to the much more flexible US economy. the government triggers fiscal policy shocks in a stepwise fashion. at least in the case of Germany. op.J. hit it hard.FORUM Seen on the whole. hiring and firing. 17 December 2008. Now that uncertainty is gradually decreasing. This implies that businesses facing only a small change in prices may not respond immediately. If. employment and consumption may appear less sensitive to changes in the fiscal policy stance than according to the prediction of the majority of models of fiscal policy transmission. C a b a l l e r o : Normalcy is Just a Few Bold Policy Steps Away. households and the economy as a whole. 33 Cf. d e G r a u w e . in: Monitoring the European Central Bank 4. it would just waste an option without helping the economy. 32 Cf.

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