In a sobering column in the Financial Times, Edward Chancellor reminds us that the late Wynne Godley was right in predicting that large private deficits in the U.S. would lead to trouble–and that the Eurozone, when it was formed, might become a tragic disinflationary trap. The end of the column is particularly noteworthy:

He went on to caution that without a common European budget, there was a danger that “the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression that it is powerless to lift”.

Rob Parenteau, a fellow Levy Institute scholar, has recently applied Prof Godley’s analysis to the eurozone periphery. Germany wants countries, such as Spain, to get their public finances in order. Yet if Spain is to reduce its fiscal deficit without too much pain, two conditions are necessary. First, the country’s trade position must shift into surplus. This is problematic since labour costs are high relative to Germany and Spain cannot devalue its currency. Second, the private sector must move back into deficit. Yet it is difficult to see Spanish households and companies wanting to borrow more given the ongoing problems caused by the collapse of the property bubble.

There is a danger the proposed fiscal tightening in the eurozone will lead to further deflation and economic collapse. The Spanish government faces what Mr Parenteau calls “the paradox of public thrift”: the less it borrows, the more it will end up owing. It is unfortunate that it has taken a severe global recession to vindicate Prof Godley’s macroeconomic analysis. If economic policymakers start to pay more attention to financial balances, they might forestall the next crisis. European politicians might also understand the potentially dreadful consequences of their new-found frugality.

You can read some of Rob’s analysis for yourself here. Chancellor, by the way, is the author of a good book called Devil Take the Hindmost: a History of Financial Speculation.