Bad Counsel

Bad Counsel

By Desmond Lachman  |  ForeignPolicy.com

 

The European Union should understand that budget tightening is a bad policy option for countries like Greece, Ireland, and Spain, which are already suffering due to their lack of independence over interest rate and exchange rate policies.

 

iStockphoto/Alex Culla i Vinals

One has to be struck by the oddity and poor timing of the European Union's call on Greece, Ireland, and Spain to begin reducing their budget deficits. At the very time that the International Monetary Fund is counseling countries to engage in aggressive fiscal stimulus to fight the worst postwar global recession, the European Union is pushing for belt-tightening. And it is doing so for those euro-zone countries that are hardest hit by the global economic crisis.
Greece, Ireland, and Spain are all neck-deep in recessions of epic proportions that will soon raise unemployment to the highest levels in the past 70 years. In Ireland and Spain, the bubbles bursting in the housing market make the United States' own predicament look benign. All three countries also must cope with a global collapse in trade and tourism.
Under usual circumstances, a country experiencing a recession of this proportion would sharply reduce its interest rates and allow for a sharp depreciation of its currency. However, stuck within the euro zone, Greece, Ireland, and Spain have to live with interest rates set by an overly cautious European Central Bank (ECB) and a euro whose relatively high price on world currency markets renders their economies grossly uncompetitive. At the very least, these countries should be allowed a reprieve from having to fight widening budget deficits even as their economies weaken.

History is littered with examples of fixed-exchange-rate countries that have tried and failed to balance their budgets in deep recessions.

History is littered with examples of fixed-exchange-rate countries that have tried and failed to balance their budgets in deep recessions by raising taxes and cutting expenditures. In counseling budget tightening for Greece, Ireland, and Spain this week, the European Union seems blithely oblivious to this experience. Policymakers in these countries need only look as far as the Baltic countries to see that economic collapse is being exacerbated by hair-shirt budget tightening.
Rather than counseling budget austerity for Greece, Ireland, and Spain, the European Union would be better advised to push for aggressive fiscal stimulus in Germany, Europe's major economy. Or how about a decidedly more expansionary monetary policy from the ECB? The German government itself now concedes that, with present policies, the German economy will contract a staggering 6 percent in 2009 before recovering only marginally in 2010. Absent more vigorous growth in that country, it is difficult to see how Greece, Ireland, and Spain can extricate themselves from deep recessions--even if they ignore the European Union's advice. This time, the real deficit to watch out for is that of common sense.

Desmond Lachman is a resident fellow at AEI.