How to Create a Depression

Jan 16, 2012 Martin Feldstein

European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression. It would be much smarter to focus on the difference between cyclical and structural deficits, and to allow deficits that result from so-called "automatic stabilizers."

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.

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Martin Feldstein

Writing for PS since 2008
130 Commentaries

Martin Feldstein was Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. He was also on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

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Kir Komrik Apr 2, 2012

I appreciate your effort in explaining your theory.

You wrote:

"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."

This is way too much Nostradamus talk for me and I have no idea how to assess the veracity of all these claims.

"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"

You seem to mention two "channels" then only discuss one. I was a little confused there. In any case,

"The franc could no longer decline relative to other eurozone currencies."

No, but the Euro could decline relative to other global currencies ...

I've discussed the EU's woes here at kirkomrik.wordpress.com

- kk
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parthasarathy Shakkottai Feb 25, 2012

"No monetarily non-sovereign can survive long-term on internal taxes or borrowing.
By contrast, Monetarily Sovereign nations do not need money coming in from outside their borders, because they create unlimited money simply by paying bills.
For Greece and the other euro nations, long term survival requires one of two, and only two, events:

1. Adopt some form of a sovereign currency, and become Monetarily Sovereign
or
2. The EU give (not lend) euros to its member nations as needed.

There are no other solutions. None." from
http://rodgermmitchell.wordpress.com/2011/11/03/there-are-two-and-only-two-long-term-solutions-for-greece-and-the-other-euro-nations/
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Nick Marshall Feb 22, 2012

Bring it on.
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Robert Mullen Feb 19, 2012

The proposed formula for exceptions to the limit on deficits, namely “natural catastrophes and serious emergency situations”, is essentially the same as President Bush's "recession, war, or national emergency" Remember how happy he was when he "hit the trifecta"?
As long as the politicians have a loophole it will be exploited. Why else suppose the difference between structural and cyclical deficients is a real one? Why else suppose higher borrowing costs during inflation are less real than otherwise? Any excuse to borrow will be validated and the borrowing will never stop.
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John Doe Jan 24, 2012

Professor Feldstein

1. It seems to me the dangers you see are very real.

2. It also seems to me that you are stuck in your thinking, for you propose no real, long term solutions. You seem to imply that Europe should abandon the Euro so that your "free market" solutions, what you call "channels of response," are foreclosed. Munger would say you have man with a hammer syndrome.

3. Implicitly, what you are saying is that, if Europe wants to keep the Euro, it must find something other than a market based solution to its problems.

4. Hamel wrote a number of years ago a very difficult book, Leading the Revolution, in which he argued that we faced a failure of ideas and ultimately "business models."

5. Dropping a currency value is only one way to re-price wine. An alternative approach would be for wine producers, suppliers and credit providers, and the gov't to jointly attack production to lower costs.

6. Sunday's NYT had a long story about this very process now taking place in China. Glossed over in the story was that the Chinese gov't paid for the building where Apple's iphone is manufactured.

7. Possible concluson: The future is not free markets it is effective crony capitalism.
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Paul Hanly Jan 19, 2012

They also failed to respond to differences in net annual balances (trade, other current account and capital) and the accumulation of those differences over time, reflecting differences in installed captial base, manufacturing capacity, general structure of economies, productivity, welfare benefits such as timing and quantum of pensions.
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Paul Hanly Jan 19, 2012

It is clear that at present the central bank is not determiniing interest rates for individual countries like France. The wide range of rates for sovereigns at the same maturities show that the bond markets are setting the rates based on fear of/estimation of probability of default
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