Posted by: Dirk | December 18, 2013

No alternative but to operate a restrictive fiscal policy that would have strong negative effects on output and employment!

For a paper I am writing I am re-reading ‘A simple model of three economies with two currencies: the eurozone and the USA’, a paper written by Wynne Godley and Marc Lavoie published in 2007 in the Cambridge Journal of Economics, which is prescient. The degree of it is just mind-boggling. Here we go (p. 1-2, my highlighting):

For instance, if one of the ‘euro’ countries starts importing too much and makes no modification to fiscal policy, the ex ante effect will be to raise the proportion of bills issued by that country and held by the ECB—in successive stages and without limit. If this becomes unacceptable, at least within the confines of the model (and always given the assumption about three independent fiscal policies), the interest rate of the deficit country must give way and become endogenous. But this would bring about an exploding situation, as the interest rate of the weak country would need to increase for ever. There is, in the end, only one lasting solution to this problem within the existing structure—to endogenise the fiscal policy of the deficit country. Faced with rising imports, unable to devalue and trapped by an unaccommodating
central bank, the ‘weak’ country would have, in the end, no alternative but to operate a restrictive fiscal policy that would have strong negative effects on output and employment. The only alternative is to modify the structure of the eurozone arrangements, either by forcing euro countries enjoying surpluses to pursue expansionary fiscal policies or by expanding the spending power of the European Union government, so it can engage in induced equalisation payments that transfer fiscal resources from surplus to deficit countries.

Let me make clear that what Godley and Lavoie write is based on a model that is ‘at once complex and elementary’ (p. 2). In other words, it is abstract. The ‘art of economics’ is to get things right even though you are using abstractions. The result of ‘no alternative’ must be understood as ‘under current arrangements’, not as ‘it is optimal that’. So, if some euro zone governments would have known that paper everyone might have been better off, and that is what economists are there for.

So, here we are in 2013, and still very serious economists tell us that ‘economists didn’t see it coming’, that the models ‘didn’t work’, that it is ‘impossible to predict the future’, and so on. Yet there are some papers out there like the one above where authors recognized the Achilles heel of certain arrangements, and the papers and authors are still almost unknown even in the discipline of economics. Unbelievable…

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