European political leaders may be about to agree to a fiscal plan that, if implemented, could push Europe into a major depression. To understand why, it is useful to compare how European countries responded to downturns in demand before and after they adopted the euro.
Consider how France would have responded in the 1990s to a substantial decline in demand for its exports. If there had been no government response, production and employment would have fallen. To prevent this, the Banque de France would have lowered interest rates. In addition, the fall in incomes would have automatically reduced tax revenue and increased various transfer payments. The government might have supplemented these "automatic stabilisers" with new spending or by lowering tax rates, increasing the fiscal deficit.
The fall in export demand would have automatically caused the franc's value to decline relative to other currencies, with lower interest rates producing a further decline. This combination of monetary, fiscal and exchange rate changes would have stimulated production and employment.
But when France adopted the euro, two of these channels of response were closed off. The franc could no longer decline relative to other euro-zone currencies. The interest rate in France - and in all other euro-zone countries - is now determined by the European Central Bank (ECB), on the basis of demand conditions within the monetary union as a whole. So the only countercyclical policy available to France is fiscal: lower tax revenue and higher spending.
While that response implies a higher budget deficit, automatic fiscal stabilisers are particularly important now that the euro-zone countries cannot use monetary policy to stabilise demand. Their lack of monetary tools, together with the absence of exchange rate adjustment, might also justify some discretionary cyclical tax cuts and spending increases.
Unfortunately, several euro-zone countries allowed fiscal deficits to grow in good times, rather than only when demand was weak. Their national debt grew because of "structural" as well as "cyclical" budget deficits.
Structural deficits were facilitated over the past decade by a lack of responsiveness in euro-zone interest rates to national differences in fiscal policy and debt levels. Because financial markets failed to recognise distinctions in risk, interest rates on sovereign bonds did not reflect excessive borrowing.
Greece's confession in 2010 that it had understated its fiscal deficit was a wake-up call to the financial markets, causing interest rates on sovereign debt to rise substantially in several euro-zone countries.
The EU's summit in Brussels last month was intended to prevent such debt accumulation in the future. The leaders of member countries agreed in principle to limit future fiscal deficits by seeking constitutional changes that would ensure balanced budgets. They agreed to cap annual "structural" budget deficits at 0.5 per cent of GDP, with penalties imposed on countries whose total fiscal deficits exceeded 3 per cent.
Negotiators are now working out the details before another meeting of EU government leaders at the end of this month. An important part of the deficit agreement last month is that member states may run cyclical deficits that exceed 0.5 per cent of GDP - an important tool for offsetting declines in demand. And it is unclear whether the penalties for total deficits that exceed 3 per cent would be painful enough for countries to sacrifice greater countercyclical fiscal stimulus.
The most frightening recent development is a formal complaint by the ECB that the proposed rules are not tough enough. Jörg Asmussen, a key member of the ECB's executive board, wrote to the negotiators saying that countries should be allowed to exceed the 0.5 per cent of GDP limit for deficits only in times of "natural catastrophes and serious emergency situations".
This would eliminate automatic cyclical fiscal adjustments, which could lead to a downward spiral of demand and a serious depression. If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5 per cent of GDP.
To remove that cyclical deficit, France would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers - and thus a bigger fiscal deficit.
This proposal could produce high unemployment rates and no route to recovery - in short, a depression. In practice, the policy might be violated, just as the old stability and growth pact was abandoned when France and Germany defied its rules and faced no penalties.
It would be much smarter to focus on the difference between cyclical and structural deficits, and to allow deficits that result from automatic stabilisers. The ECB should be the arbiter of that distinction, publishing estimates of cyclical and structural deficits. That analysis should also recognise the distinction between real - inflation-adjusted - deficits and the nominal deficit increase that would result if higher inflation caused sovereign borrowing costs to rise.
Italy, Spain and France all have deficits that exceed 3 per cent of GDP. But these are not structural deficits, and financial markets would be better informed and reassured if the ECB indicated the size of the real structural deficits and showed that they were declining. For investors, that is the essential feature of fiscal solvency.
Martin Feldstein, a professor of economics at Harvard University, was the chairman of the US president Ronald Reagan's council of economic advisers and is a former president of the National Bureau of Economic Research
* Project Syndicate
