Posted Thursday, Jan. 17, 2013, at 12:35 PM
An economic boom in the United States is good news for Canada, which exports a lot of stuff to us. By the same token, a recession in the United Kingdrom creates big problems for Ireland. Alan Auerbach and Yuriy Gorodnichenko investigate whether this means that fiscal policy creates "output spillovers" that go from one country to its trade partners and find that the answer is yes—"cross-country spillovers have an important impact, and also confirm those of our earlier papers that fiscal shocks have a larger impact when the affected country is in recession."
You can add this to the pile of reasons that conducting optimal fiscal policy as a matter of political reality is a good deal harder than it can look in a sketched out economic model. But it also explains a lot of Europe's problems.
Simply put, austerity would be working better in Italy if it weren't also being practiced in Spain and France and the United Kingdom. And austerity would be working better in France if it weren't also being practied in Spain and the United Kingdom and Italy. Lather, rinse, and repeat as you like. The point is that coordinated contractionary policy can be much more damaging than policy undertaken on its own. One of the most striking things to me about the faux-fixed eurozone crisis is that basically none of the deep institutional problems that have created the current mess have been resolved. They are, to be sure, really hard problems to resolve. But having gone in on tight economic integration, the continent's leaders really have no choice but to start trying to confront this stuff.