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Op-Ed

Europe’s So-called “Expansionary Contraction” Has Not Worked in Practice

Martin Neil Baily

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.

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