The Magic of the Market
How to Create a Depression
Martin Feldstein
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CAMBRIDGE – European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression. To understand why, it is useful to compare how European countries responded to downturns in demand before and after they adopted the euro.
Consider how France, for example, would have responded in the 1990’s to a substantial decline in demand for its exports. If there had been no government response, production and employment would have fallen. To prevent this, the Banque de France would have lowered interest rates. In addition, the fall in incomes would have automatically reduced tax revenue and increased various transfer payments. The government might have supplemented these “automatic stabilizers” with new spending or by lowering tax rates, further increasing the fiscal deficit.
In addition, the fall in export demand would have automatically caused the franc’s value to decline relative to other currencies, with lower interest rates producing a further decline. This combination of monetary, fiscal, and exchange-rate changes would have stimulated production and employment, preventing a significant rise in unemployment.
But when France adopted the euro, two of these channels of response were closed off. The franc could no longer decline relative to other eurozone currencies. The interest rate in France – and in all other eurozone countries – is now determined by the European Central Bank, based on demand conditions within the monetary union as a whole. So the only countercyclical policy available to France 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.
Unfortunately, several eurozone countries allowed fiscal deficits to grow in good times, rather than only when demand was weak. In other words, these countries’ national debt grew because of “structural” as well as “cyclical” budget deficits.
Structural budget deficits were facilitated over the past decade by eurozone interest rates’ surprising lack of responsiveness to national differences in fiscal policy and debt levels. Because financial markets failed to recognize distinctions in risk among eurozone countries, interest rates on sovereign bonds did not reflect excessive borrowing. The single currency also meant that the exchange rate could not signal differences in fiscal profligacy.
Greece’s confession in 2010 that it had significantly understated its fiscal deficit was a wake-up call to the financial markets, causing interest rates on sovereign debt to rise substantially in several eurozone countries.
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. Specifically, they agreed to cap annual “structural” budget deficits at 0.5% of GDP, with penalties imposed on countries whose total fiscal deficits exceeded 3% of GDP – a limit that would include both structural and cyclical deficits, thus effectively limiting cyclical deficits to 3% of GDP.
Negotiators are now working out the details ahead of another meeting of EU government leaders at the end of January, which is supposed to produce specific language and rules for member states to adopt. An important part of the deficit agreement in December is that member states may run cyclical deficits that exceed 0.5% of GDP – an important tool for offsetting declines in demand. And it is unclear whether the penalties for total deficits that exceed 3% of GDP would be painful enough for countries to sacrifice greater countercyclical fiscal stimulus.
The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-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. In practice, the policy might be violated, just as the old Stability and Growth Pact was abandoned when France and Germany defied its rules and faced no penalties.
It would be much smarter to focus on the difference between cyclical and structural deficits, and to allow deficits that result from automatic stabilizers. The ECB should be the arbiter of that distinction, publishing estimates of cyclical and structural deficits. That analysis should also recognize the distinction between real (inflation-adjusted) deficits and the nominal deficit increase that would result if higher inflation caused sovereign borrowing costs to rise.
Italy, Spain, and France all have deficits that exceed 3% of GDP. But these are not structural deficits, and financial markets would be better informed and reassured if the ECB indicated the size of the real structural deficits and showed that they are now declining. For investors, that is the essential feature of fiscal solvency.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisers and is former President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2012.
www.project-syndicate.org
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gamesmith94134 08:06 17 Jan 12
Gamesmith94134: Rethinking the Growth Imperative I think Kenneth Rogoff is right in the policy planning that a watermark should be drawn on the ship as it floats. Often, many economists misjudge the safety net may not be a margin that is casted on the body of the ship; it depends how it reacts when it enters a stream or river; then, it wrecks on the sandbar. Also, typhoons and Icebergs make the ship collapse; then, how is it conditioned to implosion from the social riot within or hot cash invasion from afar? So, it is not the growth imperative like per capita or living standard; it can create only delusions on the forwardness as the GPS to perpetuity; since inflation and deflation may based on the productivity or assets and relatively the satisfactory margin are based on a group to another; and how each interacts on its exchanges from another since globalization makes the values and prices individually counted and calculated. If we can return to the market system, I definitely take interest rate as my yard stick, 6.5% prime in China and 3.25% in American in a long run can tell well on inflation and deflation after the effect of productivity by the past, surpluses verse debt in the changing fiscal budget and so on. Since we had mutated interest rate that compensate risk factors as the apparatus to measure systematically, and currencies are not valued but priced to condition; then, I like better with inflation and deflation based on the cycles of business and living ambience that support its financial and social developments relatively compare to others; because they are always true based on how its people support and enjoy as it will. It is my opinion only that each economy behaves like a piece of rock or a piece of paper with equal weight, one will sink and other floats based on the surfaces they cover and how the water surface can support it based on the spread of risk factors domestic or foreign it covers. They often swap each other in its cycles as comparison is posted side by side over sovereignties. Livelihood in EU by negative growth at 0.25% may not be worsen as the African nations at positive 0.25%; rising per capita at $46,000 did not make housing boom more than its lower per capita five years ago. Therefore, uncertainty is now on all financial situation till the process of deleveraging is well settled in term of price an d value, or at least all financial would satisfy with return of the market system that interest rate represents the risk factor on its investment. Otherwise, if you are depending on the 13000 as a growth imperative, I can definitely tell you it will not last over the next three months; because we might depend on the 99% or how the 1.3 euro to a dollar can raise in the sales of the Eurobonds. However, globalized economic apply currency exchange rates, fiscal policy and more to how its people support and enjoy as it will; even after the mutation of the marketable interest rate to cover all its risk factors to growth. May the Buddha bless you?
Zsolt 01:33 18 Jan 12
This is a very good article, since even a person without high level economic knowledge as myself can understand the main points.
The problem is all its analysis and recommendations are based on a system that no longer functions.
What we see today all over the world, and most acutely in Europe, how the sailors of a sinking ship try all sorts of old tricks and maneuvers, when the ship has already lost its engine, its steering, all the sails, and even those sailors who could do the rowing when everything else fails.
Classical capitalistic free market economy is not functioning any more, because the conditions it was based on have changed. Instead of the "loose" system with free markets, easily available cheap labour, and cowboy style (many times unhuman) employment parctices we find ourselves in a global, interconnected, overlapping network, with finite, receding natural resources, with an aware, alerted public.
The middle class keeping the engine running has lost confidence, money and even employment, we have a large sized, aging population and a young generation that is uninterested, uneducated and has no future prospects, on the other hand that is globally connected through virtual networks, and easily mobilized, manipulated.
It is becoming clearer each day that almost all the products the constant growth production and consumption was based on are completely unneccessary and useless, moreover harmful for ourselves and the environment, and more and more people wake up to the truth that we kept on producing and buying as slaves because we were brainwashed to do so by the marketing machinery and the society surrounding us.
Now that people can access information within seconds the previous "circus and bread" cheap and superficial control does not work any more, especially for the young generation and the horrific inequalties and injustices in the western countries are open for everone to see.
Our problems are much deeper than just the "depression in Europe" because of some bank regulations. We are at the dead end of our civilization at all levels.
Instead of stubbornly continuing with the old tricks, going against the wall until we lose everything, we should take a deep breath, admit defeat and start working out how to build a completely new system, that is suitable for the global conditions surrounding us.
For that first of all we have to study and understand those conditions. Each day newer and newer studies, serious and respected scientific publications, video clips with politicians, economical experts, scientist on the Internt come out explaining us this new world around us, we just need to put the picture together.
As soon as we have this new foundation the infinite talent and wisdom humanity has accumulated through our history will help us build new social, political and economical structures for a better future. But we cannot bury our heads inside the sand any more.
gamesmith94134 02:58 18 Jan 12
Gamesmith94134: Why Development Aid is Not Enough
Erick Solheim is right on the development aid is not enough, because the system does not give a proper redistribution of the wealth to the poor; instead, it created the sovereignty debts for the developer nations since there is not an appropriate system to support or police the developments. It is because the ones control the funds are not subject to the necessity with lesser control in term of supply and demand, so whatever the outcome of the project is being manipulated my its participants, of the ruling class like brokers, manufacturers and financiers. Besides, they are to the projects based on profitability and control, whatever how fruitful the outcome of the project are. Profits are goes to the ruling class and never the entrepreneurs or its producers since they turned into labor by class by the ruling parties after the goods are subsidized by its government and price are controlled by the medium like future market systems or manufacturers.
Perhaps, it sounds like I am anti-market system or free trade, but throughout my years of observation through the transition of the past to present. I am seriously considering the system is at fault since the polarization of the up-rising of the labor classes or the poor and no-solution ruling class. And, I opposed the Millennium Development Goals because it does not have a proper system in maintaining the progress and misses the goal by proportion.
In example of story I heard of, the grain production in China, farmer got only 20% of the sack of wheat, the rest went to the processors or the mill, and the marketing. Does it really farmer’s four months works is lesser than a five minute phone call? Or the processor can give a better price to the public under the price control means the lower pay for farmers, the public may be subsidized under automation, or the farmer should be compensate more when he market his grain.
There is another story on the bullet train as the infrastructure developed in California, USA. It was cancelled because the cost of it went up three times as estimated; after its funds was diverged to projects for traffic congestion instead of buying lands that needed to build its train. I do not blame those refuse to sell the land at the lower price, but I cursed at those prospectors buying the land to sell---- developers with close tie to its friends on the projects.
· Do people learn anything from the ClubMed incident? From boom to doom, it is all delusions; just because the project is lack of control and prospectors are those control the progress; and the wealth does not trickle down as it thought but the middle man made it fortune with its alliance with the ruling class.
· “Since 2000, when the international community adopted the Millennium Declaration and the Millennium Development Goals (MDGs)”. Again, I question on the international community by G-20; are they work for the brokerage or the labors? And how they market their goals? I like it better if they can be inclusive to the zones of the development and monitored by the local or market system that the development can appeal it case, not brokers.
· “Power has also shifted in the global political arena, with the global financial crisis catalyzing the emergence of the G-20”, why just 20 and not all of world takes like the United Nations with full members of it working together to avoid manipulation of the prospectors. I think the farmer should know how much he deserves in the deal then he can compete on the market of the world, not to its processors or mills.
Finally, development aid is not enough indicates the lesser profit most of the needed can get; and its aid turned into subsidies for its government or prospectors for its dealing and wheeling. It certainly needs a neutral zone for the needed to compete in our present market system among its brokerage and government. Therefore, corrupted or collapsed will be evaluated by the real communities of the Zone; not to the financier or the ones who signed in the projects. There must be a resolution comes from the United Nations Security council that can stop the hegemony from ruining the global economy by manipulating and misrepresenting the world in lesser of the global totality.
Sorry! G-20, the cook does not get his best meal, and the waiter serves only its customers; and Gourmet Restaurant gave the tasteful on a few only, McDonald provides most with a full stomach for lesser price. Development aid can never be enough if it serves only a few by proportions.
May the Buddha bless you?
gamesmith94134 02:58 18 Jan 12
Gamesmith94134: Why Development Aid is Not Enough
Erick Solheim is right on the development aid is not enough, because the system does not give a proper redistribution of the wealth to the poor; instead, it created the sovereignty debts for the developer nations since there is not an appropriate system to support or police the developments. It is because the ones control the funds are not subject to the necessity with lesser control in term of supply and demand, so whatever the outcome of the project is being manipulated my its participants, of the ruling class like brokers, manufacturers and financiers. Besides, they are to the projects based on profitability and control, whatever how fruitful the outcome of the project are. Profits are goes to the ruling class and never the entrepreneurs or its producers since they turned into labor by class by the ruling parties after the goods are subsidized by its government and price are controlled by the medium like future market systems or manufacturers.
Perhaps, it sounds like I am anti-market system or free trade, but throughout my years of observation through the transition of the past to present. I am seriously considering the system is at fault since the polarization of the up-rising of the labor classes or the poor and no-solution ruling class. And, I opposed the Millennium Development Goals because it does not have a proper system in maintaining the progress and misses the goal by proportion.
In example of story I heard of, the grain production in China, farmer got only 20% of the sack of wheat, the rest went to the processors or the mill, and the marketing. Does it really farmer’s four months works is lesser than a five minute phone call? Or the processor can give a better price to the public under the price control means the lower pay for farmers, the public may be subsidized under automation, or the farmer should be compensate more when he market his grain.
There is another story on the bullet train as the infrastructure developed in California, USA. It was cancelled because the cost of it went up three times as estimated; after its funds was diverged to projects for traffic congestion instead of buying lands that needed to build its train. I do not blame those refuse to sell the land at the lower price, but I cursed at those prospectors buying the land to sell---- developers with close tie to its friends on the projects.
· Do people learn anything from the ClubMed incident? From boom to doom, it is all delusions; just because the project is lack of control and prospectors are those control the progress; and the wealth does not trickle down as it thought but the middle man made it fortune with its alliance with the ruling class.
· “Since 2000, when the international community adopted the Millennium Declaration and the Millennium Development Goals (MDGs)”. Again, I question on the international community by G-20; are they work for the brokerage or the labors? And how they market their goals? I like it better if they can be inclusive to the zones of the development and monitored by the local or market system that the development can appeal it case, not brokers.
· “Power has also shifted in the global political arena, with the global financial crisis catalyzing the emergence of the G-20”, why just 20 and not all of world takes like the United Nations with full members of it working together to avoid manipulation of the prospectors. I think the farmer should know how much he deserves in the deal then he can compete on the market of the world, not to its processors or mills.
Finally, development aid is not enough indicates the lesser profit most of the needed can get; and its aid turned into subsidies for its government or prospectors for its dealing and wheeling. It certainly needs a neutral zone for the needed to compete in our present market system among its brokerage and government. Therefore, corrupted or collapsed will be evaluated by the real communities of the Zone; not to the financier or the ones who signed in the projects. There must be a resolution comes from the United Nations Security council that can stop the hegemony from ruining the global economy by manipulating and misrepresenting the world in lesser of the global totality.
Sorry! G-20, the cook does not get his best meal, and the waiter serves only its customers; and Gourmet Restaurant gave the tasteful on a few only, McDonald provides most with a full stomach for lesser price. Development aid can never be enough if it serves only a few by proportions.
May the Buddha bless you?
ArtP 09:02 18 Jan 12
It's a valid fear but one that applies to the whole planet rather than just Europe. The probable cause of a world wide recession is that we are using resources at a rate which is not sustainable.
If this is true then policy makers face an impossible dilemma.
Policies which lead to recession will hurt a lot of people and especially the poor. In this case the line between rich and poor will likely be quite high.
The conventional wisdom is that to deal with a recession goverments should spend to stimulate the economy even if they have to go massively into debt.
Stimulating the economy when there is resource depletion is going to deplete resources even faster and will bring forward a major crash.
A further complication is that the Euro zone financial crisis will likely lead to a sharp reduction in the money supply. Without money the exchange of goods and services will be curtailed.
Resource depletion combined with a loss of money supply has the potential to be disasterous. But it should leave a few resources for the survivors.
(The author of this comment has a web log on economics at https://economics102.wordpress.com/)
Hlafordlaes 07:07 19 Jan 12
Excellent point. Wonder why the data and analysis are not available; seems a textbook distinction.
gamesmith94134 07:08 16 Feb 12
Damien89 and Fatbikez,
Taking someone’s front end to another’s rear end is a lewd act, orally speaking. Grow up. Auto, real estate went down. PPI rose to 2.6
Are you being depressed?
http://www.gocomics.com/features/search?search_string=foxtrot
WaltFrench 09:07 16 Jan 12
Unfortunately, several eurozone countries allowed fiscal deficits to grow in good times, rather than only when demand was weak. In other words, these countries’ national debt grew because of “structural” as well as “cyclical” budget deficits.
Unfortunately, some major North American economies allowed both public and private indebtedness to soar during the last decade, too. Difference seems to be that we have a Fed that's sympathathetic to compensating for past Fed errors.