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level of aggregate demand. In a recession, an expansionary fiscal policy involves lowering taxes and increasing government spending. In an overheated expansion, a contractionary fiscal policy requires higher taxes and reduced spending. According to Keynes, a recession requires deficit spending while an overheated expansion requires a budget surplus. 1) Discretionary Fiscal Policy. The first way this can be done is through the federal budget process. However, this process takes so long -- 12 to 18 months -- that it is difficult to match discretionary fiscal policy with the business cycle. The expansionary Kennedy tax cut of 1964 and later the contractionary Ford tax increase of 1974 hit the economy just when the opposite contracyclical policy was needed. As a result, the federal government will only use discretionary fiscal policy in a severe recession, such as 1981-82 and 2008-09. In both cases, the federal government resorted to a large fiscal stimulus ± tax cuts in 1981-82 and increased spending in 2008-09. Both policies created large deficits, which is the appropriate stabilization policy during a severe downturn. 2) Automatic Stabilizers. A second type of fiscal policy is built into the structure of federal taxes and spending. This is referred to as "nondiscretionary fiscal policy" or more commonly as "automatic stabilizers". The progressive income tax (the major source of federal revenue) and the welfare system both act to increase aggregate demand in recessions, and to decrease aggregate demand in overheated expansions. These automatic changes in spending and taxes will generate a deficit in recessions and a surplus in overheated expansions. The size of these automatic changes can be quite large. Iin the 2008-09 recession the deficit stimulus due to the automatic stabilizers was much larger than the stimulus created by the legislative changes in taxes and spending (discretionary fiscal policy). Monetary policy is under the control of the Federal Reserve System (our central bank) and is completely discretionary. It is the changes in interest rates and money supply to expand or contract aggregate demand. In a recession, the Fed will lower interest rates and increase the money supply. In an overheated expansion, the Fed will raise interest rates and decrease the money supply. These decisions are made by the Federal Open Market Committee (FOMC) which meets every six to seven weeks. The policy changes can be done immediately, although the impact on aggregate demand can take several months. Monetary policy has become the major form of discretionary contracyclical policy used by the federal government. A source of conflict is that the Fed is independent and is not under the direct control of either the President or the Congress. This independence of monetary policy is considered to be an important advantage compared to fiscal policy.
not the Eurozone. General government consolidated gross debt Source: European Commission. Prior to the eruption of the financial crisis in 2007.Note that expansionary monetary policy is commonly called "easy money" while contractionary monetary policy is called "tight money". The culprit is a profligate private banking sector that has put strain on otherwise manageable government finances. This column argues that its cause is misunderstood. i. which shows the debt to GDP ratios in the Eurozone and the US since 1999. AMECO An outsider looking at this figure would surely conclude that if one country is likely to be hit by a sovereign debt crisis it should be the US. The increase in debt has reached crisis point because the Eurozone is a monetary union without being a political union ± it has no fire brigade to put out the fire. A government debt crisis is ravaging the Eurozone. Why? Hidden differences and no mechanism The answer is to be found in the fact that the average debt to GDP ratio of the Eurozone hides . Fighting the wrong enemy Paul De Grauwe 19 May 2010 Print Email Comment Republish A government debt crisis is ravaging the Eurozone. the two debt ratios were converging. In 2010 the US government debt ratio will be 10 percentage points higher than in the Eurozone.e. Yet when comparing the development of government debt in the Eurozone with that of the US it is striking to find how much more benign the trends in sovereign debt are in the Eurozone compared to the US. Other terms are also used. This is made clear in Figure 1. Figure 1. Yet it is the Eurozone that is hit by the crisis. If there has been government profligacy (as is now often claimed to be the cause of the debt crisis in the Eurozone) it seems to be the case more in the US than in the Eurozone. Since the start of the financial crisis we observe a significantly faster increase of the government debt ratio in the US than in the Eurozone. the Eurozone government debt ratio tended to decline while the US government debt ratio tended to increase.
Some countries like Greece and Italy have very high public debt levels. and Asdrubali et al. The contrast with the US is stark. Von Hagen 1991. AMECO The differences are striking. to automatically organise transfers to the country experiencing these problems.e. i. These are shown in Figure 2. These divergences however are considerably alleviated by the fact that the centralised Federal budget automatically redistributes to the deficit regions without anyone noticing. Figure 2. A majority of countries in the Eurozone. which after all represents only 2% of Eurozone GDP.4 dollars flow back to the state through the federal budget (see for example Sachs and Sala-i-Martin 1989. Yet it has appeared impossible to do so. triggering in turn contagion to other countries that the market perceived to be next in line for possible default. As a result.large differences between countries and that the Eurozone does not have a mechanism to deal with these differences. This situation has raised concerns about the capacity of these countries to continue to service their debts in an environment of low economic growth. Given the overall strength of the government finances within the Eurozone it should have been possible to deal with a problem of excessive debt accumulation in Greece. It has been estimated that for every dollar decline in income at the state level. experience a debt dynamics that is benign certainly when compared to the US (and also the UK). 1996). General government consolidated gross debt Source: European Commission. between 0. . however. Deficit and surplus regions also exist in the US. others such as Ireland and Spain have public debt levels that are increasing fast.2 and 0. The reason is that there is no mechanism to ³internalise´ this problem. the Greek sovereign debt crisis was left hanging high and dry. Let us first concentrate on the size of the differences.
the latter was busy trying to punish the guilty before it started extinguishing the fire. making a fire brigade necessary. If they do so. as with any insurance mechanism. When it finally set up a fire brigade. And an important detail: This fire brigade should be willing to extinguish the fire before it punishes the guilty. They appear to be vindicated today. their hands were forced. but they reduce the need for the deficit state or country to borrow in the capital markets. completely discarded any form of automatic insurance mechanism. This is absent in the Eurozone (see Asdrubali et al. if they are always well-behaved. there is the risk of moral hazard. however. An explicit fiscal union is not the only way to provide for an insurance mechanism within a monetary union.What is the Eurozone missing? The heart of the problem is that the Eurozone is a monetary union without being a political union. In much the same way. Thus it can be said that the Eurozone had an elaborate set of rules to prevent fires and decided that therefore it would not need a fire brigade. While it is understandable that countries were not willing to automatically transfer resources to deficit countries it is less understandable that so many lived in the illusion that a monetary union could function smoothly without it. 1996 and Mélitz and Zumer 1999. or by a European Monetary Fund. governments never intended to save banks. The Stability and Growth Pact would do the trick ± just make sure that countries abide by the rules. events can force them to do so. at some point a monetary union will force member countries to show some solidarity ± whether they like it or not. see De Grauwe 2009). The truth is that there will always be some people who do not follow the rules scrupulously. This is like saying that if people follow the fire code regulations scrupulously there is no need for a fire brigade. For a survey. without the need to organise an explicit decision making process. Automatic transfers do not solve the problem of adjustment of states or countries. A fire code without a fire brigade The official doctrine in the Eurozone has been that an insurance mechanism is not necessary for a smooth functioning of the Eurozone. The main reason was that. Many economists have stressed in the past that such an insurance mechanism is essential for a smooth functioning of the monetary union (in the economists¶ jargon. to ensure optimality of a monetary union). but when a banking crisis erupted. It can also be organised using the technique of a monetary fund that obtains resources from its members to be disbursed in times of crisis (and using a sufficient amount of conditionality). The present crisis shows that even if countries never intended to provide assistance to others. No wonder the fire spread to other countries. Such a proposal has recently been made by Gros and Mayer (2010). . there is no need for an automatic insurance mechanism provided by a centralised budget. In a political union there is a centralised budget that provides for an automatic solidarity mechanism in times of crisis. i. Likewise.e. Thus the existence of a centralised budget creates an automatic solidarity (insurance) mechanism allowing countries to draw on the resources of other countries when facing a negative shock. The design of the Eurozone. The need to avoid moral hazard was the main reason why the Eurozone was created without any insurance mechanism. This is the risk that governments will exploit the existence of an insurance mechanism to create excessive debts and deficits. The trouble with the Eurozone is that when events force countries to practice solidarity there is no mechanism to do this smoothly.
and CEPS While the government debt ratio in the Eurozone declined from 72% in 1999 to 67% in 2007) the household debt increased from 52% to 70% of GDP during the same period. This is shown in Figure 3. As was stressed earlier. y y With the exception of Greece. under pressure from the German government. Policymakers using incorrect analysis of the fundamentals In addition. prior to the emergence of the financial crisis the government debt to GDP ratio in the Eurozone was declining. Let me elaborate on this. y y It is now repeated continuously that the source of the debt crisis in the Eurozone is the profligacy of national governments.The recent proposals developed by the European Commission. AMECO. in particular the financial sector. the Eurozone governments were more disciplined than the private sector in containing their debt. This connection is particularly strong in countries like Spain and Ireland that have been hit badly by the debt . The explosion of the government debt after 2007 was the result of a necessity to save the private sector. Financial institutions increased their debt from less than 200% of GDP to more than 250%. Those who say that it is government profligacy that is the source of the debt crisis are mistaken. continue to follow the logic of strengthening the fire code rules and ignoring the need to create a fire brigade that is willing to extinguish the fire before it punishes the reckless. the diagnosis of the causes of the crisis underlying these proposals is wrong. Figure 3. They also fail to see the inevitable connection between private and public debt. private debt (households and financial institutions) increased in an unsustainable way. Private and government liabilities in the Eurozone (share of GDP) Source: European Commission. During the same period. It is clear that this approach is not workable once a crisis erupts.
which followed the fire code regulations most scrupulously. would do little to avoid the kind of crisis that the Eurozone experiences now. In this sense the Commission is fighting the wrong enemy. some countries (not only in Southern Europe) allowed unsustainable real estate and consumption booms to emerge and to be financed by bank debt. which followed the rules of the Stability and Growth Pact better than any other country ± certainly better than Germany that allowed its government debt ratio to increase before 2007. Such a political union should ensure that budgetary and economic policies are coordinated preventing the large divergences in economic and budgetary outcomes that have emerged in the Eurozone. In all fairness it should be added that there is an important new and positive element in the recent Commission¶s proposals. These were the two countries. . because they failed to contain domestic private debt. This has everything to do with the build-up of major imbalances involving the private sector. i. but it cannot be repeated enough that the structural problem of the Eurozone is the absence of a sufficiently strong political union in which the monetary union should be embedded. in particular private debt levels. Spain from 60% to 40% and Ireland from 43% to 23%. Such a proposal. even if it implies solidarity with the sinners. were hit by the fire. As can be seen from Figure 2.e. These imbalances will occur even when all countries follow balanced budget rules. This ³fighting-the-wrong-enemy´ syndrome is even more pronounced in the recent proposal made by the German government to impose balanced budget rules in all the Eurozone countries.crisis. This is that not only the government budget debts and deficits must be monitored. It also implies that an automatic mechanism of financial transfers is in place to help resolve financial crises. The issue here is how this monitoring can be made effective so as to avoid new crises. As argued earlier. One can have doubts whether this can be achieved without a further transfer of sovereignty to European institutions. Mutual solidarity cannot be avoided in a monetary union. A fire code without a fire brigade: Fighting the wrong enemy The European Commission¶s recent proposals continues to follow the philosophy still that the fire code regulations must be strengthened while nothing is done to create an effective fire brigade. Spain and Ireland were spectacularly successful in reducing their government debt to GDP ratios prior to the financial crisis. Conclusion It has often been said. Thus it appears that the German government¶s proposal to install balanced budget rules is a major coverup of its own responsibility in contributing to the imbalance within the Eurozone. Yet the two countries. but also the private sector imbalances. if implemented. Much of the financing of these unsustainable booms was done by the ³virtuous´ countries with current-account surpluses.