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Proponents of fiscal stimulus often call on Germany to adopt a more expansionary fiscal policy, in the hope that this will help rebalance and reflate the entire eurozone. It’s possible it might work, but it’s also possible it might end up being a “beggar-thy-neighbor” policy.

Suppose the ECB is targeting inflation. Fiscal stimulus in Germany will be partly offset (in Germany) by tighter monetary policy. The ECB will want to keep overall eurozone inflation on target. Hence it will offset any impact on NGDP. But some of the effect of tighter eurozone monetary policy will be felt in the other countries. So if total eurozone NGDP and inflation are unaffected by the two policy changes, and German NGDP rises, then it is necessarily true that non-German NGDP falls.

Possible objections:

1. The ECB would never be that cruel. It’s not about the ECB being cruel; it’s about the ECB doing its job. A better counterargument is that the ECB is incompetent and won’t do its job.

2. The argument doesn’t apply at the zero bound. I would remind you that during over 90% of the past 6 years the ECB has been doing normal monetary policy, raising and lowering its interest rate target with the goal of stabilizing inflation. Only very recently has it hit the zero bound. And yet people have been calling for German fiscal expansion for years. And it’s also worth noting that fiscal proponents who claim that the zero bound “changes everything” were spectacularly wrong in their 2013 prediction that austerity would slow growth in the US. That doesn’t mean that monetary offset applies in each and every case—the ECB is unusually incompetent, but it’s certainly the baseline assumption.

3. This is one of those ivory tower theories that don’t match the real world. And yet the idea of fiscal stimulus being a beggar-thy-neighbor policy is actually the standard textbook explanation for the European exchange rate crisis of September 1992. Germany did a massive fiscal stimulus in the early 1990s, to help rebuild East Germany. This pushed up real interest rates in the ECU area. The higher real interest rates (combined with a Bundesbank monetary policy tight enough to prevent inflation) led to recession (or aggravated an existing recession) in countries like Britain and Sweden. Eventually they were forced to devalue, and to this day remain outside of the euro.

So fiscal expansion in one country within a currency zone is a beggar-thy-neighbor policy in both theory and practice. Over at Econlog, I have a new post explaining why low interest rates do not call for more public investment.

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