Don't trust the bankers' homilies
The EU stability pact destabilises by cutting spending in a downturn
Joseph Stiglitz
Friday May 9, 2003
The Guardian
France, Portugal and Germany are all flagrantly flouting the stability pact,
the agreement among eurozone members to keep their deficits below a critical
threshold (3% of GDP today, but lower, supposedly, in the future). France's
prime minister, Pierre Raffarin, defends his government's position by saying
that France was not prepared to impose austerity on its own people. If
France will not, other European leaders must wonder, why should they?
Mr Raffarin was right to say that austerity would result if France obeyed
the pact's strictures, but in debates over economic policy, the truth is
seldom appreciated. There is a long list of central bankers' homilies that
are not supposed to be questioned. Do so and you are exiled from the circle
of those who supposedly know how the world "really" works. Here are three:
An independent central bank is necessary for sound macroeconomic policy. The
truth: countries that do not have an independent central bank, such as
India, manage to contain inflation as effectively as those with independent
central banks. In Russia, an independent central banker, Viktor Gerashencko,
could not be removed for years, though he tolerated both inflation and
corruption. Generally, there is little evidence that countries with
independent central banks grow faster, have higher wages, or generate higher
incomes - indeed, that they perform better in any real sense than those that
do not.
Once inflation starts, it increases at a faster and faster rate, and the
costs of reversing it are high. The truth: there is no evidence of an
inflation precipice, or that the costs of reversing inflation (in terms,
say, of pushing unemployment to high levels) are any greater than the
benefits from inflation (in terms, say, of allowing unemployment to fall to
low levels).
Inflation is bad for growth and productivity. The truth: below a critical th
reshold - a threshold far beyond the levels of inflation that now prevail in
Europe and North America - there is no evidence of significant adverse
effects from inflation. On the contrary, recent research by Nobel laureate
economist George Akerlof and his colleagues suggests that pushing inflation
too low may impede growth, and that the critical threshold is higher for
countries, such as the post-communist transition economies, engaged in large
structural changes.
When an economy faces a downturn, one should engage in expansionary fiscal
policies. But in a downturn tax revenues fall. Thus, debt must increase. But
the EU's stability pact, as commonly interpreted, requires either that tax
rates be raised (always difficult, especially in a recession) or that
expenditures be cut. Either way, such policies will exacerbate the downturn.
The stability pact put into place an automatic economic destabiliser. But
the EU - indeed, every country - should seek stabilisers, policies that
automatically boost the economy in a downturn. The US is facing, albeit in a
weaker form, a similar problem.
Most of America's 50 states have constitutional amendments that effectively
impose a balanced budget. As tax revenues drop due to the economic downturn,
the states are cutting back on expenditures, exacerbating America's slump -
and the world's. I warned of this problem more than a year ago, and I
suggested that the federal government pick up the tab for the shortfall in
state tax revenue, because the states did not cause the country's slowdown.
At the time, there was some disagreement about how long the downturn would
last (I was a pessimist, and unfortunately I have been proved right). But I
argued that this was irrelevant: making up the states' shortfall would cost
the government nothing if the optimists turned out to be right, but it would
be just the right medicine if pessimists like me were correct. Instead, the
Bush administration pushed ahead with tax cuts for the rich, tax cuts that
were not designed to stimulate the economy and that, no surprise, have
failed to stimulate the economy.
The lesson for Europe is clear: the EU should redefine its stability pact in
terms of the structural or full employment deficit - what the fiscal deficit
would be if the economy were performing at full employment. To do otherwise
is irresponsible.
There does need to be a commitment to fiscal responsibility. In the long
run, governments should run balanced budgets, with surpluses in good years
making up for deficits in bad years. But to insist on an arbitrary budgetary
position in an economic downturn is to ignore everything we have learned
about economics in the past 70 years, risking the well-being of millions who
are thrown out of employment.