The real “beggar-thy-neighbor” policy

Proponents of fiscal stimulus often call on Germany to adopt a more expansionary fiscal policy, in the hope that this will help rebalance and reflate the entire eurozone.  It’s possible it might work, but it’s also possible it might end up being a “beggar-thy-neighbor” policy.

Suppose the ECB is targeting inflation. Fiscal stimulus in Germany will be partly offset (in Germany) by tighter monetary policy. The ECB will want to keep overall eurozone inflation on target.  Hence it will offset any impact on NGDP.  But some of the effect of tighter eurozone monetary policy will be felt in the other countries. So if total eurozone NGDP and inflation are unaffected by the two policy changes, and German NGDP rises, then it is necessarily true that non-German NGDP falls.

Possible objections:

1.  The ECB would never be that cruel.  It’s not about the ECB being cruel; it’s about the ECB doing its job.  A better counterargument is that the ECB is incompetent and won’t do its job.

2.  The argument doesn’t apply at the zero bound.  I would remind you that during over 90% of the past 6 years the ECB has been doing normal monetary policy, raising and lowering its interest rate target with the goal of stabilizing inflation.  Only very recently has it hit the zero bound.  And yet people have been calling for German fiscal expansion for years.  And it’s also worth noting that fiscal proponents who claim that the zero bound “changes everything” were spectacularly wrong in their 2013 prediction that austerity would slow growth in the US. That doesn’t mean that monetary offset applies in each and every case—the ECB is unusually incompetent, but it’s certainly the baseline assumption.

3.  This is one of those ivory tower theories that don’t match the real world.  And yet the idea of fiscal stimulus being a beggar-thy-neighbor policy is actually the standard textbook explanation for the European exchange rate crisis of September 1992.  Germany did a massive fiscal stimulus in the early 1990s, to help rebuild East Germany.  This pushed up real interest rates in the ECU area. The higher real interest rates (combined with a Bundesbank monetary policy tight enough to prevent inflation) led to recession (or aggravated an existing recession) in countries like Britain and Sweden.  Eventually they were forced to devalue, and to this day remain outside of the euro.

So fiscal expansion in one country within a currency zone is a beggar-thy-neighbor policy in both theory and practice.  Over at Econlog, I have a new post explaining why low interest rates do not call for more public investment.


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19 Responses to “The real “beggar-thy-neighbor” policy”

  1. Gravatar of Philippe Philippe
    16. November 2014 at 10:28

    “The ECB will want to keep overall eurozone inflation on target.”

    But overall eurozone inflation is not on target.

  2. Gravatar of Daniel Daniel
    16. November 2014 at 10:51

    the ECB is unusually incompetent

    Oh, I’d say they are quite competent. They certainly can achieve whatever they want to achieve. It’s just that what they want isn’t ending the recession.

    The problems in Europe are political – namely, a unified Germany.

  3. Gravatar of ssumner ssumner
    16. November 2014 at 12:03

    Philippe, But the question is why—and what does the ECB expect to happen to inflation over the next few years? And is this what the ECB wants to happen to inflation over the next few years. Did they raise interest rates in 2011 because inflation was too high? I say yes.

    Daniel, If you are right then I am right.

  4. Gravatar of Luis (Miguel) Luis (Miguel)
    16. November 2014 at 12:21

    I don’t know so much people demanding for a German’s fiscal policy. At least not in the sense of a compressive proposal of monetary and fiscal measure. The waves against the euro are rising in the south, and perhaps the idea of fiscal expansion is to contain them. UKIP, Sirytza, Podemos, Le Pen, etc, have as its main objective the end of the Euro. Sooner or later someone will reach the target. This would be the result of so many years of great misleading in both policies. Sure, it would be also the end of EU.
    Too late to little ideas.

  5. Gravatar of ThomasH ThomasH
    16. November 2014 at 12:36

    IF ECB were doing its job we would not need to call on Germany to do more than any other country in the EU, invest in projects with positive net present values.

    The point of calling on Germany to do more is the idea (not unreasonable to me) that ECB would not offset the “stimulus” of a higher German deficit and would in fact allow a slightly higher growth/slower decline in NGDP.

    More to the point we should hope they would prod ECB to restore NGDP to a higher growth path.

  6. Gravatar of Rajat Rajat
    16. November 2014 at 12:51

    Haha, so I presume you don’t agree with this?: http://mainlymacro.blogspot.com.au/2014/11/can-we-have-our-instrument-back.html

  7. Gravatar of anon anon
    16. November 2014 at 12:52

    Fiscal stimulus in Germany (and other non-troubled countries) could help by lifting natural interest rates and taking the ECB off the zero lower bound. This would mostly be a political and institutional change, in that restoring ‘conventional’ interest-rate policy might force the ECB to act more competently and transparently.

    On the other hand, if you’re worried about recession in the southern EU countries _and_ excess inflation in Germany, and you think that the ECB can’t do much better than it’s doing right now, then you’d want the very opposite policy prescription: enact fiscal austerity in Germany, and let the ECB keep overall AD on target.

    It’s a hard question, the answer is not straightforward at all.

  8. Gravatar of The real "beggar-thy-neighbor" policy « Economics Info The real "beggar-thy-neighbor" policy « Economics Info
    16. November 2014 at 13:00

    […] Source […]

  9. Gravatar of TravisV TravisV
    16. November 2014 at 14:26

    Great stuff!

    Market monetarism is so much simpler than New Keynesianism.

    What are the primary explanations for why so many elite economists are stuck in the mud of New Keynesian complexity?

    https://www.themoneyillusion.com/?p=3316

    https://www.themoneyillusion.com/?p=25769

  10. Gravatar of TravisV TravisV
    16. November 2014 at 15:58

    Example where Prof. Sumner bends over backwards to be nice:

    https://www.themoneyillusion.com/?p=13353

    Notice he called this Christina Romer interview “excellent”:

    http://fivebooks.com/interviews/christina-romer-on-learning-great-depression

    I read that interview and Sumner disagrees with so so so many things Romer said in that interview……

  11. Gravatar of TravisV TravisV
    16. November 2014 at 15:59

    Wow, Robert Barro:

    http://fivebooks.com/interviews/robert-barro-on-lessons-great-depression

    “Bernanke was thinking that way in April 2008. I remember talking to him at the time, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.”

  12. Gravatar of Marketman Marketman
    16. November 2014 at 16:28

    They end will be ugly. The problem is figuring out when it will actually end. I have been trading the 4-6 week swings based off of Woody Dorsey’s sentiment timing.

    One thing he has said for a while-the markets are rigged-and just forget about the bigger picture. With the massive moves we have seen, I have to agree.

    He did nail the exact top and bottom dates-3 weeks ahead of these turns. I have no idea how he does it-but he is worth the read. Here is a peak at some of his calls.

    http://www.sentimenttiming.com/free/

  13. Gravatar of Benjamin Cole Benjamin Cole
    16. November 2014 at 18:35

    I would prefer very aggressive and sustained monetary stimulus in Europe, for probably the next five to seven years.

    That said, maybe the Europeans should consider going in whole hog—no more austerity, while going to big money printing, structural impediment whacking, the whole thing.

    In other words, the goal of European government should be on robust economic growth, and back-burner the inflation fetish for a good long while.

    Does anyone know that the US economy grew at an average rate that topped 3% from 1982 to 2007, while inflation was just below 3%?

    In the US, real output more than doubled from 1982 to 2007 (in fact, up 125%).

    Why would anymore care about moderate inflation, if you can more than double real output in a 25-year stretch?

    The economics profession, and economic policymakers, have lost perspective.

  14. Gravatar of ThomasH ThomasH
    16. November 2014 at 19:12

    “Over at Econlog, I have a new post explaining why low interest rates do not call for more public investment.”

    You explain that a decline in interest rates does call for more public sector investment more unless there is a simultaneous decline in the yield on public investment. The policy rule, increase investment in projects whose NPV become positive remains valid. Following this rule would look like “fiscal stimulus” most of the time.”

  15. Gravatar of ssumner ssumner
    16. November 2014 at 19:13

    anon, Maybe. But as I said, over most of the past 6 years the zero bound hasn’t been the constraint. The constraint is the mentality of the ECB. Until that changes . . .

  16. Gravatar of Majromax Majromax
    16. November 2014 at 22:42

    Nick Rowe looked at this issue a few months ago from the perspective of fiscal authorities either leading or following the Central Bank:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/08/the-ecb-cant-move-last.html

  17. Gravatar of PoorRicardo PoorRicardo
    17. November 2014 at 01:25

    You could look at German fiscal stimulus as an offset to the ECB, which has held monetary policy too tight for years. This is just the straight reverse of the Summer critique. Looser monetary policy from the ECB would be first-best, but that doesn’t seem to be forthcoming.

  18. Gravatar of Nick Nick
    17. November 2014 at 04:09

    Could the ECB possibly feel more comfortable buying German debt than peripheral? I guess I’m pointing at some combo of #1 and 3 … I would not advocate extra German spending based on this theory, but I would bet on ‘ECB fails to fully offset’ if pushed.

  19. Gravatar of ssumner ssumner
    17. November 2014 at 15:54

    Nick, They might be more comfortable, but that’s unrelated to German fiscal stimulus. There is already plenty of German debt for them to buy, a bit more won’t make any difference.

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