Wednesday, 8 December 2010

Would a common fiscal policy solve Europe’s problems?

Note dated 14th Jan 2011. This post has been rather superseded by a post dated 14th Jan 2011.

The current conventional wisdom is that it would. I’m not convinced.

Suppose there had been some sort of centralised European fiscal authority between say 2000 and 20008. Would those running it have nipped PIG type problems in the bud? That is, would they have spotted that anything was wrong before the credit crunch arrived and it was blindingly obvious to everyone that something was wrong? Where ARE these geniuses with better forsight than everyone else?

And even if these geniuses exist, there is another and somewhat technical problem, as follows.

A major problem with common currency areas occurs, as is now widely appreciated, where the competitiveness of constituent countries diverge. Where such countries each have their own currency, those who have lost relative competitiveness can devalue. In a common currency area they allegedly cannot do this.

Well actually they could, though doing so is complicated and messy. The way to do it, assuming an X% devaluation is required, is to cut all wages in the country concerned by X%. As is the case where a country with its own currency does an X% devaluation, the X% wage cut does cut living standards, but not by anything near X%. This is because the wage of natives of the country concerned forms a significant part, and usually the vast bulk, of the cost of goods and services consumed in the country concerned.

Now presumably what is meant by “common fiscal policy” is something resembling what is currently taking place in Ireland, but in slow motion. In other words the minimum wage, social security benefits, and a few other items are cut, allegedly well before the problems we now see materialise.

But cutting those two items plus a few more, is nowhere near the same as cutting ALL wages. Presumably the idea is that cutting the above two items will eventually result in wages drifting downwards (at least relative to wages in more competitive countries). But the “drifting down” is bound to take several years. The relevant country will have to endure a long period of deflation and unnecessary unemployment in the meantime.

A better alternative would be to cut employers’ contribution to any payroll tax (National Insurance contribution in the U.K.). That would reduce the cost of employing people, which in turn would reduce the cost of the relevant country’s exports and possibly rectify the balance of payments position.

1 comment:

  1. The reasoning is that automatic stabilisers also stabilise geographically, isn't it?

    Germany as a region has a trade surplus, so it pays more taxes (reduces demand) to the central fiscal authority.

    Greece, on the other hand, has a trade deficit, so it pays less taxes and the centrally funded automatic stabilisers that either employs people directly or makes sure they get unemployment benefits (increases demand).

    My opinion is that such a policy is pointless, though. The economies of the Eurozone are very heterogenous and have become more so since we had the Euro.

    National, floating currencies would do a better job.



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