Posted by: Dirk | December 20, 2008

Coordinated European Fiscal Policy

A fiscal stimulus increases demand. That is why politicians and economists consider this instrument today. Demand has fallen in the economy, people are shifting investment in durable consumer goods, like cars, into the future. The problem is not that the incomes of the people have gone down. Wages in most EU countries have increased this year, and inflation is on its way down. A falling real wage can hence not be an explanation. It is different with wealth. Trillions were lost on world markets, so people feel poorer than a year ago.

If we follow the recipe of the Austrian School, which is to sit out the downturn and do nothing, we will probably see a repeat of the Great Depression. Rising unemployment causes income to fall, this depresses demand further, leading to more shedding of workers, and so on. This will bring us back to the stone age, before we can start a recovery. Factor inputs will sit idle for a long time, causing a big loss. This loss is not necessary.

If the government increases demand by fiscal spending, than resources that would else not be used can be used to increase the GDP. In good times, this would cause so-called crowding out, the substitution of private investment by government investment. But today this is no problem: private firms are not investing anyway, so resources are free for use.

On the financial side, government investment (and consumption) has to financed by government bonds. Since interest rates are close to zero and falling, it is cheap to get money. This implies that people want to hold government debt, accepting low positive interest rates in return for absolute safety of their asset. If people shift their portfolio positions towards government debt (by selling private company assets), finance for private enterprise is getting very difficult. The interest rates are high, and credit is scarce in the sense that credit might be rationed by banks so that not all wishes for credit will be fulfilled to full extent.

It is this decision of financial market players of whether to hold risky, high interest rate risky private enterprise debt, or low interest rate secure government debt. In the last years, high interest rates have been perceived as big opportunities to make money. That drove stock market indice to new heights. Now the appetite for high interest rate bearing debt has decreased, since it is now understood (again) that a high interest rate means high risk.

Now, if a country conducting fiscal policy, some of the demand created is satisfied by way of imports. This creates so-called spillovers to the trade partners. In the EU, the most important trade partners are the EU neighbors. Therefore, it is possible that Germany, which is sitting in the middle of the EU, can benefit from fiscal expansions of its 9 neighbors (you might test your knowledge of European geography here) while doing nothing herself.

So, this kind of strategic behavior of adjusting policies to the policies of others is treated in a field called game theory. But this case is very simple. If all EU countries save for Germany increase government spending, Germany can free-ride. The other countries than have to increase their debt in order to pay for the fiscal policy, while Germany gets all the benefits without having to pay anything.

Since Germany’s government debt carries the lowest interest rates and the budget is only slightly in the red, Germany should push ahead and take responsibility for a big push herself. Other countries like Italy or Greece have to pay higher interest rates on their government debt, plus they are running government deficits close to 3%, and according to the stability and growth pact (SGP) they cannot move too far above the (arbitrary) 3% line. The SGP should be abolished quickly, since it is an obstacle for the policy needed to restore stability and growth in the European Union.


  1. […] Nevertheless, I agree that Germany should join a coordinated fiscal stimulus by the European Union. Tomorrow I will explain why. (Tomorrow became Saturday.) […]

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