by: Martin Feldstein, Project Syndicate
Cambridge - European political leaders may be about to agree to a
fiscal plan which, 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, for example, would have responded in the 1990’s
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 stabilizers” with new spending or by
lowering tax rates, further increasing the fiscal deficit.
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