The International Economy

Europe's So-called "Expansionary Contraction" Has Not Worked in Practice

Supported by academic research, many policymakers in Europe argued that fiscal consolidation could actually be expansionary. Cutting government spending, in particular, would encourage private sector investment and consumption by more than enough to offset the direct reduction of government demand. Former ECB President Jean-Claude Trichet was a strong advocate of this view.

“Expansionary contraction,” as it came to be called, has not worked in practice, as evidenced by Ireland, Greece, and Spain. Academic support for the view has also been undermined by a reappraisal of the evidence at the International Monetary Fund. Current forecasts suggest that the eurozone and probably the whole European Union are now entering a second recession, with even Germany showing signs of weakness. The big danger in fiscal consolidation is that it creates a downward spiral, where falling demand and employment trigger declining tax revenues and budget deficits actually get worse instead of better. Further spending cuts or tax increases only worsen the downward spiral.

This does not mean that fiscal consolidation can always be avoided, or that expansionary fiscal policy is the answer. Troubled eurozone economies are facing high interest rates as they roll over their maturing sovereign debt, and they can reach a point of no return where borrowing costs are so high that investors no longer believe the debt will be repaid and the market freezes up. Greece, of course, faced that situation and was forced to default.

The eurozone countries as a whole do have the power to contain their debt crisis, but so far the stronger countries have not been willing to guarantee the obligations of the weaker ones. No one wants to bail out the very large debts of Italy or Spain. The chances are pretty good that Germany and France, with help from the European Central Bank and the IMF, will muddle through and avoid a deeper crisis, but the participants are playing with fire. The continued uncertainty in Europe could trigger the collapse of major financial institutions that would be hard to contain. The strong economies are right to demand transparency and accountability in the fiscal accounts of countries that are asking for help, but they should look for a long-run approach to budget balance and not demand draconian budget cuts in the short run.

The United States is not helping. It is blocking the International Monetary Fund from using U.S. funds to help resolve the crisis, which is a mistake. A deeper crisis in Europe would trigger a second recession in the United States.