In these days where conservative orthodoxy has gone so far to the extreme right, it is encouraging to see a prominent conservative economist point out what should be obvious: that adoption of stringent fiscal rules for balanced budgets by Eurozone members, as are being emphatically pushed by Angela Merkel and other Eurozone leaders, could easily cause an economic contraction turn into an economic depression.
Professor Martin Feldstein of Harvard, a prominent establishment figure, has made this point in his posting yesterday on the Project Syndicate web-site here. The argument is clear and easy to understand, and should be read in its entirety. I have copied below some of the key sections. And Professor Feldstein is not a liberal economist: he was Chairman of the Council of Economic Advisers under President Reagan, was the long-time head of the National Bureau of Economic Research, and was a prominent adviser to President George W. Bush, including as a proponent of Bush’s plan to privatize Social Security.
While the point being made by Professor Feldstein should be obvious, it appears that Eurozone members will soon adopt such balanced budget rules, and some have already adopted variants. Germany is pushing strongly, and the members are currently in no position to oppose what Germany wants. Yet implementation of contractionary policies in an attempt to cut fiscal deficits caused by an economic contraction will put economies on a path to depression. And similar rules are being pushed for the US by prominent Republicans and especially by Tea Party activists.
It is a formula for turning a downturn into a depression, as was done in the 1930s.
How to Create a Depression
European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression.
[With the adoption of the Euro] the only countercyclical policy available to France [or any Eurozone member] is fiscal: lower tax revenue and higher spending.
While that response implies a higher budget deficit, automatic fiscal stabilizers are particularly important now that the eurozone countries cannot use monetary policy to stabilize demand. Their lack of monetary tools, together with the absence of exchange-rate adjustment, might also justify some discretionary cyclical tax cuts and spending increases.
The European Union’s summit in Brussels in early December was intended to prevent such debt accumulation in the future. The heads of member states’ governments agreed in principle to limit future fiscal deficits by seeking constitutional changes in their countries that would ensure balanced budgets.
The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situations” outside the control of governments.
If this language were adopted, it would eliminate automatic cyclical fiscal adjustments, which could easily lead to a downward spiral of demand and a serious depression. If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5% of GDP.
If France must remove that cyclical deficit, it would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers – and thus a bigger fiscal deficit and calls for further fiscal tightening. It is not clear what would end this downward spiral of fiscal tightening and falling activity.
If implemented, this proposal could produce very high unemployment rates and no route to recovery – in short, a depression. …