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.