Paul Krugman has a post this morning pointing out that in a standard Mundell-Fleming model, a fiscal contraction in Europe will have a negative effect on its trading partners in a floating rate environment: it not only lowers total European demand, but also leads to a weakening euro. Now, the latter effect is driven by lower European interest rates, and as Krugman acknowledges this channel won’t be working in a textbook manner in a world where European interest rates are almost (if not quite) at the zero bound; but the euro is indeed weakening as we speak, and Americans are getting worried.

There is broader point here. In a Mundell-Fleming world, with floating exchange rates, fiscal expansion is good for one’s trading partners: it involves a positive externality. Whenever you have positive externalities, there is a risk that not enough of whatever produces those externalities will be provided. Thus, in 2009, when fiscal policy was on the agenda, an important role of international coordination was to ensure that nations not try to free ride off each other’s stimulus packages. Cooperation was relatively easy to sustain: the world economy faced a clear and present danger, and nations benefitted from each other’s programmes.

In 2010 things look very different. Fiscal policy has gone into reverse in several countries, and so the focus will presumably shift to monetary and currency policy. But while fiscal stimulus helps a county’s trading partners, currency depreciation hurts them. (More generally, in a Mundell-Fleming floating rate world, expansionary monetary policy in one country hurts other countries — though again the fact that interest rates are almost at zero complicates the analysis.) So, we have moved from a world where macroeconomic policy involved positive spillovers to one where it is likely to involve negative spillovers — a much more ‘beggar-thy-neighbour’ world.

Expect lots of protectionist rhetoric in the months ahead.

17 replies on “Spillovers”

I think the protectionism has always been there – it’s just that they tone down the rhetoric every now and again for political purposes.

Though the ECB policy rate has remained at 1% since May 2009, euro (i.e German) bond yields, notably at short-end of the curve, have fallen in recent months, both in absolute terms and relative to US yields, which may partly reflect the expected dampening effect of fiscal tightening on euro area growth, and which may also be consistent (I use that word very advisedly!) with the fall in euro against dollar…

That’s why gold is at record levels.

Everyone cannot simultaneously devalue their currencies against everyone else. But all paper currencies could end up devalued against the hard currency of gold. Markets appear to be anticipating that anyway.

Morgan Stanley chief economist Richard Berner said last week that fears about the strong dollar are overblown.

First, while the euro has weakened a great deal versus the dollar, the greenback has strengthened only modestly on a broad, trade-weighted index basis (the TWI). The Fed’s broad index has risen by about 4% since mid-April and by 6% since December 1st.

Second, growth is far more important than currency movements in driving trade, prices and profits, and MS see only modest risks to global growth. Finally, much of the dollar’s recent strength reflects a flight-to-quality bid symptomatic of – – and idiosyncratic to – – the European sovereign debt crisis.

While the MS FX team expects the euro to decline to 1.16 against the dollar this year, it expects the dollar to weaken again versus AXJ (Asia ex Japan) and other currencies, leaving the broad dollar TWI little changed for the balance of the year and into 2011.


“And the US needs to be thinking about how to insulate itself from European masochism.

The pendulum will swing again; the EUR/USD rate went from about 1.18 in Dec 2005 to 1.60 in July 2008.

The currencies are the two top reserve currencies; what should one expect?

@ Cormac Lucey

The current gold price would need to almost double to hit the inflation-adjusted record set in Jan 1980.

“In a Mundell-Fleming world, with floating exchange rates, fiscal expansion is good for one’s trading partners: it involves a positive externality.”

Surely this depends on the extent of the crowding out.

If fiscal expansion-led growth comes at the price of debt crises which curb growth at a greater pace than the fiscal stimulus, then everyone loses.

Speaking of which: At what point to the Keynesian advocates of irresponsible public borrowing start admitting all this soveriegn debt they screamed for might have been a bad idea?

“The current gold price would need to almost double to hit the inflation-adjusted record set in Jan 1980.”

And it will in due course Mr. Hennigan, and it will.

@ Garo


The FT’s Lex commented last month that when financier George Soros called gold “the ultimate bubble” earlier this year, many observers falsely interpreted it as a cue that the great speculator was eschewing the barbarous relic.

Instead, he bought exposure and has made a tidy profit so far. Lex said the difference between Soros and the decidedly less-smart money that has helped push gold to a record high is that he has the proper historical perspective. Gold has only enriched those who have known when to sell it to a greater fool.

Correct. And the less astute observers missed the future tense in Soros’ statement. He said “When interest rates are low we have conditions for asset bubbles to develop, and they are developing at the moment. The ultimate asset bubble is gold.” He expects the bubble to develop for a while yet.

Good point overall on the increasing risk of less cooperative policy making.

Good point Ribbit too on crowding out. Public money is driving out private cash ever nore clearly, in many areas. For one, consider the implications for Ireland if SPV-led financing replaces national issuance.

Good point too, Michael Crowley, about lower short rates reflecting the dampening effect of (expected) fiscal ‘tightening’ and driving the euro lower… ​a very welcome development (for Europe).

I’m not sure about “Fiscal policy has gone into reverse in several countries”. Really? A bit like driving cars at breakneck speed, and thinking about pulling back on the throttle for fear of falling into the ditch. Coming to a stop, let alone “into reverse”, seems a long way off still. A nice image, but no recognition of the deleterious long term impact of still ultra expansionary policies today, cooperative or otherwise.

I struggle to understand this reasoning.
We have had a very large recession which has decimated the government finances of many European countries-to the point where the markets believe that their solvency is threatened.
Unchecked, this brings the real threat of a disorderly collapse of the Euro,an event which wd make the demand deficits and government imbalances which currently exist, pale into insignificance in comparison.
So Europe has no option except to engage in deficit reduction.
In the meantime Euro interest rates are at historic lows, a position at which,incidentally, they arrived at only after the recession threat horse had long bolted. However low interest rates are bolstering demand in Europe, thus assisting global economic activity, and to the extent to which the fiscal adjustment keeps demand lower than is necessary to maintain inflation within the ECB’s target, will stay low and will continue to bolster demand.
In the meantime, the dollar exchange rate analysis quoted by Michael Hennigan suggests that overall exchange block movements are consistent with the global US/ASIA/Europe rebalancing which is needed.

Exactly where is private money being crowded out in the Irish economy?
Same all cries for austerity by the people that mosts directly benefited from the 2009 mega bailout,eg bank analysts/strategiest/economists.

Only critisism and no real proposals about how to get unemployment down and reduce inequalities, that are the real objectives of any economic policy.

Inequalities are what Adam Smith’s invisible hand is all about!

To address them socially, you elect a government that robs you blind! There is no such thing as public funds. It all belonged to someone, once. This is a management issue. If you give massive amounts of power or money to someone else and they realize that they are unaccountable, what happens?

Banking, shadow banking and plain counterfeiting via derivatives, has enabled massive amounts of “money” to be created. In doing so houses have swelled and are bursting in value. Stocks are slowly falling back to pre bubble valuations. Hot money is now flowing into FX markets. The values are being destroyed by clever operators as we speak. Sharks meeting bigger ones. Eventually, what remains of this money will go into things appropriate for a Kondratieff winter: Gold, land that is undervalued and cash. This can take a long time. The real economy will deflate as the deflation chases hot funds out of it into the investment arena. Everything else loses nominal value. Labour, energy, buildings, services, all drop. Welcome to your future! The deflation is not to be feared! It is the normal scheme of things.

This is going to remain a fiat world.

In the NWO, it is likely to intensify, hence the restrictions on use of cash.

Adjustments will be made rationally, but there is still large volatility until all the created money finds a home. Some rational decisions will unwind. Speculators will have access to these funds. Weakness, fake or real, will be attacked. The aim is to make more ……

@ Crowded out,

Oh there are proposals for getting UE down which do not involve inflating irresponsible govt spending:

First get the budget balanced through choice expend cuts, and targeted tax hikes (mostly against the rich). Then direct govt activity solely at identified market failures.

A lean, corruption-free govt which provides an efficient legal system and covers a handful of market failures is all a small, open economy like Ireland’s needs to prosper.

None of the forecasts take into account the European ‘black economy’ of drugs, etc. How much longer will this cyclops perspective hold sway. Every proverbial dog in the street knows that the black economy across southern and eastern Europe is very significant. The day before yesterday one of the leading Sicilian winemakers (Franesceo Lena) was arrested on suspicion of ‘associating’ with the mafia. Perhaps economist already allow for its presence in consumption. I don’t know, but any light shed on the matter would be appreciated.

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