Month: January 2015

Must- and Shall-Reads:

• Paul Krugman: Those Radical VSPs
• Avery Palmer: States with Weak Gun Laws and Higher Gun Ownership Lead Nation in Gun Deaths, New Data for 2013 Confirms
• Alan S. Blinder: Beware of Woolly-Minded Attacks on the Fed
• Joseph E. Stiglitz: Europe’s Lapse of Reason

 

1. Gernot Wagner: Climate Shock: It’s Not Over ‘Til the Fat Tail Zings: “Presenting his new book ‘Climate Shock’ co-authored with Martin Weitzman. If you had a 10 percent chance of having a fatal car accident, you’d take necessary precautions. If your finances had a 10 percent chance of suffering a severe loss, you’d re-evaluate your assets. So if we know the world is warming and there’s a 10 percent chance this might eventually lead to a catastrophe beyond anything we could imagine, why aren’t we doing more about climate change right now? We insure our lives against an uncertain future–why not our planet?…”

2. Jeet Heer: The New Republic’s Legacy on Race: From Du Bois to the Bell Curve: “Between the late ’30s and the mid-’70s, The New Republic was one of the best magazines outside the black press in its coverage of the rise of the civil rights movement. Thomas Sancton, Sr., managing editor from 1942–1943, was a particularly radical advocate, holding FDR’s feet to the fire for his compromises with the Jim Crow South, and doing brave reporting on the Detroit race riots of 1943…. [But when] the country’s conversation about race turned to more ambiguous debates over busing, affirmative action, and overcoming economic hurdles. The owner who would oversee that new era was Martin Peretz…”

3. Jaume Ventura: Capital in the 21st Century: “On 19th December, CEPR and the Bank of England hosted a joint workshop to discuss Thomas Piketty’s seminal work ‘Capital in the 21st Century’. Chaired by the Bank’s Chief Economist Andy Haldane, the panel comprised Orazio Attanasio, Tim Besley, Peter Lindert, Thomas Piketty and Jaume Ventura…”

4. Daniel Davies: Rules for Contrarians: 1. Don’t whine. That is all: “I like to think that I know a little bit about contrarianism. So I’m disturbed to see that people who are making roughly infinity more money than me out of the practice aren’t sticking to the unwritten rules of the game…. The whole idea of contrarianism is that you’re… setting out to annoy people…. If annoying people is what you’re trying to do, then you can hardly complain when annoying people is what you actually do. If you start a fight, you can hardly be surprised that you’re in a fight. It’s the definition of passive-aggression and really quite unseemly, to set out to provoke people, and then when they react passionately and defensively, to criticise them for not holding to your standards of a calm and rational debate. If [Levitt and Dubner’s] Superfreakonomics wanted a calm and rational debate, this chapter would have been called something like: ‘Geoengineering: Issues in Relative Cost Estimation of SO2 Shielding’ [rather than ‘Global Cooling’], and the book would have sold about five copies….

5. As Safe as Houses: “According to… Oscar Jorda, Moritz Schularick and Alan Taylor, the traditional view that banks primarily lend to businesses is out of date. In 1900 only 30% of bank lending was to buy residential property; now that figure is around 60%…. The growth of mortgage lending has led to property bubbles and financial instability… rising levels of mortgage debt are a better predictor of financial crises than surges in other forms of lending… financial crunches caused by mortgage binges result in deeper recessions and slower recoveries than episodes caused by other forms of debt. If mortgage lending is so risky, why are bankers so keen on it? The answer lies partly in public subsidies for mortgages, which have boosted home-owner…”

Should Be Aware of:

• Daniel Davies (2012): The Christmas Sermon 2012–“On Not Believing In Canada”
• Mark Ames: Andrew Sullivan is not the Future of Journalism
• Steve M.: Kathleen Paker: The Republicans Forced Palin to Embarrass Herself

 

1. Jeet Heer: The New Republic’s Legacy on Race: From Du Bois to the Bell Curve: “The magazine’s myopia on racial issues was never more apparent than in Peretz’s and editor Andrew Sullivan’s decision in 1994 to excerpt The Bell Curve…. The book had not been peer-reviewed, nor were galleys sent to the relevant scientific journals… ‘swept forward by a strategy that provided book galleys to likely supporters while withholding them from likely critics.’… The magazine can be seen as not just reflecting the media’s diversity problem, but actively contributing to it. Because most of the critiques were political and philosophic in nature, many readers were left with the false impression that the book had some scientific validity. By the time devastating scientific reviews appeared… the book already enjoyed unmerited prestige, thanks to the imprimatur of The New Republic. The Bell Curve was perhaps the most impactful, and unfortunate, example of the magazine’s embrace of racial mythmaking…”

2. Peter Weinhart: Rape and Consolatio: “Augustine is the first to address rape victims with consolatio, and in so doing he turns consolation into social critique: [Melanie Webb] ‘his consolation cannot simply be an exhortation to rape-survivors to re-orient themselves within a society that regards them with shaming suspicion. It must also be an admonition to civil leaders to re-orient society toward rape-survivors as dignified women without requiring “proof” of innocence. Augustine initiates his project of social criticism through the genre of consolatio’…”

3. : The New Republic’s Legacy on Race: From Du Bois to the Bell Curve: “A 1995 piece by Ruth Shalit argued that if The Washington Post hired strictly on merit, it would be an all-white newspaper: ‘The Post, of course, is in an agonizing position. If editors refuse to adjust their traditional hiring standards, they will end up with a nearly all-white staff. But if they do reach out aggressively to ensure proportionate representation for each relevant minority, they transform not just the complexion but the content of the paper.’ Shalit’s piece made no mention of the fact that the magazine she was writing for had an almost all-white editorial staff. After the piece appeared, roughly half of the 28 Post staffers Shalit interviewed wrote in to say that she had either lied about what they told her or misrepresented them; The New Republic printed only a fraction of these complaints…. Likewise… Stephen Glass penned a 1996 piece about the Washington, D.C. taxi cab industry that seemed to cater to Peretz’s appetite for melodramas illustrating black cultural pathology…. One may also ask if a staff dominated by privileged white males might not have benefited from greater diversity, and not just along racial lines. ‘Marty [Peretz] doesn’t take women seriously for positions of responsibility,’ staff writer Henry Fairlie told Esquire magazine in 1985…”

4. Fredrik deBoer: I don’t know what to do, you guys: “You’ll forgive me when I roll my eyes at the army of media liberals, stuffed into their narrow enclaves, responding to Chait by insisting that there is no problem here and that anyone who says there is should be considered the enemy…. The culprits overwhelmingly were not women of color. That’s always how this conversation goes down: if you say, hey, we appear to have a real problem with how we talk to other people, we are losing potential allies left and right, then the response is always ‘stop lecturing women of color.’ But these codes aren’t enforced by women of color, in the overwhelming majority of the time. They’re enforced by the children of privilege. I know. I live here. I am on campus. I have been in the activist meetings and the lefty coffee houses…. I know I’ll get read the intersectionality riot act, even though everyone I’m criticizing here is white, educated, and privileged…. Christ, I wish people would think outside of their social circle for 5 minutes…. I want a left that can win, and there’s no way I can have that when the actually-existing left sheds potential allies at an impossible rate. But the prohibition against ever telling anyone to be friendlier and more forgiving is so powerful and calcified it’s a permanent feature of today’s progressivism. And I’m left as this sad old 33 year old teacher who no longer has the slightest f—ing idea what to say to the many brilliant, passionate young people whose only crime is not already being perfect…”

5. Michelle Goldberg: Jonathan Chait and the New PC: “Unlike some of Chait’s critics, I think there is such a thing as renascent political correctness…. But… he conflates several different things… genuine suppression of speech… annoying rhetorical tropes of online discourse… energetic debate…. Chait describes a torrent of online derision directed at his friend Hanna Rosin under the hashtag #RIPpatriarchy. In Chait’s version, the hashtag is a reaction to her book, The End of Men…. In fact, the hashtag was spurred by a related Slate piece with the trollish headline, ‘The Patriarchy is Dead: Feminists, accept it.’ The patriarchy not being dead, feminists did not accept it. That’s not stifling political correctness. It’s responding to speech with more speech…. ‘Her response since then has been to avoid committing a provocation, especially on Twitter,’ Chait writes of Rosin…. Social media has dramatically raised the psychic cost of voicing unpopular opinions…. To which, I suspect, many on Twitter would reply boo-fucking-hoo…. For Twitter’s guardians of righteousness, if privileged journalists feel more inhibited about bucking lefty pieties, so much the better…. Such a style, of course, was a hallmark of the Old New Republic… the magazine mistook common prejudice for unspoken truths…”

Hoisted from the Archives: The conventional Fisher-Friedman approach to the determination of nominal spending and income focuses on the equilibrium demand and supply of money through the quantity theory:

(1) PY = MV(i)

If the economy’s money-supply process has produced “too little” money for the current level of spending, businesses and households attempt to shift their portfolios and accumulate more money by (i) trying to sell some of their other financial assets for cash, and (ii) cutting back on their spending. Thus the flow of spending—and income, and production—falls until PY has fallen by enough to make households and businesses no longer seek to increase their money holdings. Combine this focus on money supply and money demand equilibrium with some model of price theory and price adjustment, and the result is a theory of the monetary business cycle.

At the zero-interest rate lower nominal bound, this Fisher-Friedman framework breaks down. With no opportunity cost to holding wealth in money rather than in other short-duration safe nominal assets, there is no reason for changes in the money stock to induce any changes in the flow of spending at all. Anybody seeking to model nominal and real income determination must then find another, alternative equilibrium condition to focus on.

The conventional theoretical macroeconomic step to take is to focus on the intertemporal Euler equation of a representative household with rational expectations: is it on an optimal consumption-savings path? But focusing on the Euler equation requires that there be (a) no disagreements between investors, and (b) a meaningful representative household, with (c ) correct rational expectations. If we are unwilling to make those assumptions, we are then driven back to the equilibrium condition from which, given the existence of no disagreements, a representative household, and rational expectations, the Euler equation was derived.

This equilibrium condition–appropriate for a more general theory—-is the Wicksell-Hicks flow-of-funds through financial markets condition: the supply of savings vehicles must be equal to the demand for savings vehicles. If the demand for savings vehicles is greater than the supply, people will cut back on spending their savings on currently-produced goods and services as they try to boost their holdings of savings vehicles. Spending, production, and incomes will fall until people feel so poor that they no longer wish to boost their holdings of savings vehicles. When the supply of savings vehicles is greater than demand, people will increase their spending as they try to turn their excess asset holdings into current consumption. Spending, production, and incomes will rise until the richer society is happy holding the existing supply of savings vehicles.

Thus theories about the effectiveness or ineffectiveness of any kind of policy—monetary, fiscal, banking, whatever—at the zero nominal interest rate lower bound are ways of deploying Wicksell-Hicks flow-of-funds equilibrium condition. They are theories about:

(2) B + S = B + I + (G – T)

about the demand for savings vehicles—the sum of the current stock of financial assets in the economy B and desired additions to that stock through savings S—and the supply of savings vehicles—the sum of the current supply of financial assets B plus business investment I plus government debt issuance G – T.

Note that if you wish to assume a (a) representative agent with (b) rational expectations you are still committed to an analysis via (2). It is a consequence of your intertemporal Euler equation. If and only if (2) holds, then your representative agent with rational expectations is on its optimal consumption-savings path.

Equation (2) gives us insight into the potential effectiveness of monetary policy at the zero lower bound. Such non-fiscal policies do not, by definition, change the supply of savings vehicles: they simply swap one savings vehicle in private portfolios for another—cash for Treasuries, short Treasuries for GSEs, private obligations subject to bankruptcy risk for private obligations backstopped by a government guarantee. For them to boost the economy therefore, they too must work via their effects on reducing private savings S or boosting private investment I.

How can they do this?

Mostly, they do this by convincing financiers that the path of real interest rates will be lower in the future than they had expected. Even though at the zero nominal lower bound the current size of the money stock is irrelevant because the opportunity cost of holding money is zero, this will not always be the case. Someday the size of the money stock will matter again. And if the central bank now takes steps that credibly promise such a larger money stock in the future when it matters, then expectations of lower nominal interest rates and higher price levels in the future which should boost investment and other real interest-sensitive components of spending now.

What are these policies?

Jawboning to reduce anticipated real interest rates: The central bank can claim that it will maintain interest rates in the future at a lower level and the money stock at a higher level than that of its normal policy reaction function. Thus, the central bank would claim, inflation will be higher in the future than forecasts based on normal reaction functions would allow. That means that real interest rates will be lower—and that would push down savings and push up investment.

The potential difficulty is that open-market operations can be unwound. That the Federal Reserve has raised the money stock this year does not necessarily mean that it will keep the money stock five years hence above the level called for by its standard reaction function. Pure jawboning is the ultimate in cheap talk. Jawboning backed by quantitative easing at the short end of the term structure is not quite pure cheap talk: the central bank is taking action. The problem is that the action is easily reversible.

Quantitative easing at the short end to reduce anticipated real interest rates: The central bank can claim that it will maintain interest rates in the future at a lower level and the money stock at a higher level than that of its normal policy reaction function—and back up those claims by expanding the money stock now by continuing to buy short-term government bonds for cash even though this is simply a swap of one zero-yielding short term safe nominal asset for another. The idea is that the Federal Reserve is not just claiming it will expand the money stock in the future—it has already expanded the money stock.

The potential difficulty is that open-market operations can be unwound. That the Federal Reserve has raised the money stock this year does not necessarily mean that it will keep the money stock five years hence above the level called for by its standard reaction function. Pure jawboning is the ultimate in cheap talk. Jawboning backed by quantitative easing at the short end of the term structure is not quite pure cheap talk: the central bank is taking action. The problem is that the action is easily reversible.

Quantitative easing at the long end to reduce anticipated real interest rates: The central bank can claim that it will maintain interest rates in the future at a lower level and the money stock at a higher level than that of its normal policy reaction function—and back up those claims by expanding the money stock now by to buying long-term government, agency, and private bonds for cash and committing to holding them to maturity. The idea is that the Federal Reserve is not just claiming it will expand the money stock in the future—it has already expanded the money stock. And such transactions are not or at least are not as easily unwound. Price pressure effects mean that the Federal Reserve will, embarrassingly, probably lose money on the round trip if it breaks its commitment to hold its purchased securities to maturity.

Quantitative easing at the long end may have another significant effect as well. By taking duration and, in the case of private bonds, default risk onto its balance sheet the Federal Reserve transfers that risk from the marginal investor to the marginal taxpayer. If the marginal taxpayer is at a corner solution in their financial market holdings or has a higher rate of time discount than the marginal investor or simply does not see through the government’s balance sheet, one consequence of quantitative easing at the long end is that investors will then have unused risk-bearing capacity. Duration and default risk spreads should then fall, and this fall in spreads should turn more investment projects into positive NPV ones. Quantitative easing at the long end thus has not only its potential principle effect on private investment and other forms of interest-sensitive spending via expectations of inflation and thus of real safe interest rates but also a secondary effect on investment via the government’s assumption of a role as a risk-bearing partner in private enterprise.

Back-of-the-envelope calculations based on standard finance principles suggest that this portfolio-composition effect should be insignificantly small. But similar arguments based on standard finance principles have long suggested that standard open-market operations in normal times should not be able to shake the intertemporal price system out for thirty years either, and there is a lot of evidence that standard open market operations in normal times do in fact have substantial effects.

Quantitative easing accompanied by declarations that the central bank has not changed its long-run inflation and price level targets: I do not understand why a central ban would pursue such a policy.

But that is the policy that the Federal Reserve appears to have decided to pursue.

Ryan Avent:

Monetary policy: The Fed’s communications problem: As I’ve written before, the commitment to allow higher inflation in the future is one of the key methods through which the central bank can have a positive effect on an economy stuck at the zero lower bound. The Fed’s efforts to clarify and push out the date at which it is likely to raise rates strikes me as a means to try and commit itself to higher inflation in the future. But the Fed’s communications efforts in this regard run up against a serious obstacle in the form of the Fed’s long-term inflation forecast, which is 2%. The Fed can’t force future central banks to keep to any policy path. If the Fed were to project a long-run inflation rate above 2% then, as Mr Bini Smaghi says, markets might suppose that monetary tightening lay ahead, whatever the fine print says.

This is not an unsolvable problem but is, I think, one of the tight spots in which the Fed finds itself as it transitions from a framework that wasn’t very good at boosting the economy at the ZLB to one that might be. One way to get around the problem would be to change the target, to 3% inflation or to something else, like a price or nominal GDP level, that implies future inflation above currently acceptable levels. The Fed may get there eventually, but probably not soon enough to have a meaningful impact on this recovery.

An alternative might be to bring the point at which future inflation is tolerated a bit closer to the present. That is, the Fed doesn’t necessarily run into problems of inconsistency if it projects inflation above 2% 1 or 2 years from now—a timeframe over which markets readily understand this group of policymakers to have control—while maintaining the long-run 2% goal. Achieving that would require the Fed to give itself a framework within which it’s acceptable to have inflation above 2% (and even to try to generate inflation above 2%), and as I wrote last week, I thought the Fed took a big step in that direction at its latest meeting. But one then has to choose to act within that framework. I suspect that what that will take is a near-term projection of inflation above 2% combined with action—asset purchases—designed to demonstrate that, yes, the Fed is actually trying to create a little catch-up inflation. At the last press conference, Ben Bernanke all but admitted that that would be a sensible thing to do. Now we just need to excise the “all but”.

2025 words

Gernot Wagner: Climate Shock: It’s Not Over ‘Til the Fat Tail Zings: “Presenting his new book ‘Climate Shock’…

…co-authored with Martin Weitzman. If you had a 10 percent chance of having a fatal car accident, you’d take necessary precautions. If your finances had a 10 percent chance of suffering a severe loss, you’d re-evaluate your assets. So if we know the world is warming and there’s a 10 percent chance this might eventually lead to a catastrophe beyond anything we could imagine, why aren’t we doing more about climate change right now? We insure our lives against an uncertain future–why not our planet?…

**Jeet Heer**: [The New Republic’s Legacy on Race: From Du Bois to the Bell Curve](http://www.newrepublic.com/article/120884/new-republics-legacy-race): “Between the late ’30s and the mid-’70s…>…*The New Republic* was one of the best magazines outside the black press in its coverage of the rise of the civil rights movement. Thomas Sancton, Sr., managing editor from 1942–1943, was a particularly radical advocate, holding FDR’s feet to the fire for his compromises with the Jim Crow South, and doing brave reporting on the Detroit race riots of 1943…. [But when] the country’s conversation about race turned to more ambiguous debates over busing, affirmative action, and overcoming economic hurdles. The owner who would oversee that new era was Martin Peretz…

Jaume Ventura: Capital in the 21st Century: “On 19th December…

…CEPR and the Bank of England hosted a joint workshop to discuss Thomas Piketty’s seminal work ‘Capital in the 21st Century’. Chaired by the Bank’s Chief Economist Andy Haldane, the panel comprised Orazio Attanasio, Tim Besley, Peter Lindert, Thomas Piketty and Jaume Ventura…

Apropos of Jonathan Chait’s “Not a Very P.C. Thing to Say” and Hanna Rosin’s “The Patriarchy Is Dead”, some constructive advice from Daniel Davies:

Daniel Davies: Rules for Contrarians: 1. Don’t whine. That is all: “I like to think that I know a little bit about contrarianism…

…So I’m disturbed to see that people who are making roughly infinity more money than me out of the practice aren’t sticking to the unwritten rules of the game…. The whole idea of contrarianism is that you’re… setting out to annoy people…. If annoying people is what you’re trying to do, then you can hardly complain when annoying people is what you actually do. If you start a fight, you can hardly be surprised that you’re in a fight. It’s the definition of passive-aggression and really quite unseemly, to set out to provoke people, and then when they react passionately and defensively, to criticise them for not holding to your standards of a calm and rational debate. If [Levitt and Dubner’s] Superfreakonomics wanted a calm and rational debate, this chapter would have been called something like: ‘Geoengineering: Issues in Relative Cost Estimation of SO2 Shielding’ [rather than the book being subtitled ‘Global Cooling’], and the book would have sold about five copies….

The other point of contrarianism is that, if it’s well done, you assemble a whole load of points which are individually uncontroversial (or at least, solidly substantiated) and put them together to support a conclusion which is surprising and counterintuitive…. Because of this, if you’re writing a contrarian piece properly, you ought to be well aware of what point it looks like you’re making, because the entire point is to make a defensible argument which strongly resembles a controversial one. So having done this intentionally, you don’t get to complain that people have ‘misinterpreted’ your piece by taking you to be saying exactly what you carefully constructed the argument to look like you were saying…. A degree of diffidence is appropriate here, because the confusion is entirely and intentionally your fault: ‘(That is the ‘global cooling’ in our subtitle. If someone interprets our brief mention of the global-cooling scare of the 1970’s as an assertion of ‘a scientific consensus that the planet was cooling,’ that feels like a willful misreading.)’ No it doesn’t; it feels like someone read the first two pages for the plain meaning of the words and didn’t spot that you were actually playing a little crossword-puzzle game… ‘global cooling’ meant, it was put on the cover in full knowledge of the impression it would give… so… it is not legitimate to complain that this phrase was interpreted in the way in which it was intended to be interpreted. In general, contrarians ought to have thick skins, because their entire raison d’etre is the giving of intellectual offence to others. So don’t whine, for heaven’s sake. Own your bullshit…

Readings:

• FastFT: Greek bond rout deepens as Syriza fears mount – fastFT
• Paul Krugman: Greece: Think Flows, Not Stocks
• Paul Krugman: Thinking About the New Greek Crisis
• Daniel Davies: Greece, the EU and Aunt Agatha
• Daniel Davies: Greek games and scenarios
• Barry Eichengreen: Eurozone breakup would trigger the mother of all financial crises

Sokrates Son of Sophroniskos: You are out of your century, and out of your country…

Titus Pomponius Atticus: I claim this to be my country, and here by the docks of the Piraeus to be my place. I am not called “Atticus” for nothing, you know…

Axiothea: Why are you called “Atticus”? It doesn’t sound like a very Roman name…

Atticus: I made it up. My father had only two names–good old Titus Pomponius, no claims to triple-barreled noble senatorial-class names he, just an equestrian.

Sokrates: So you have a triple-barreled name because?

Atticus: My mother wanted it: Caecilia Metella–one of the Metelli. Her family was at the top in the years surrounding my birth, providing the Republic with seven consuls in the generation between 123 BC and 98 BC: Quintus Caecilius Metellus Balearicus, Lucius Caecilius Metellus Dalmaticus, Lucius Caecilius Metellus Diadematus, Marcus Caecilius Metellus, Gaius Caecilius Metellus Caprarius, Quintus Caecilius Metellus Numidicus, and Quintus Caecilius Metellus Nepos.

Hypatia: “BC”?

Atticus: So it’s an anachronism. Sue me?

Glaukon: “Caprarius”? “Goat”?

Atticus: Don’t ask. So, anyway, I had to have a triple-barreled name. So my mother insisted I choose one. And I chose Atticus…

Glaukon: But what are you doing out of your century?

Atticus: What are you doing out of yours? This isn’t the Piraeus of the fifth century BC: This is a twenty-first century AD container port.

Aristokles: So then why are we here?

Daniel Davies: Syriza has won the Greek elections. There has been a lot of rather contradictory comment on what the party’s negotiation strategy might actually be, but nevertheless, it certainly seems that the ‘ultimatum’ approach to debt reduction is very much on the table, and in any case, a dogmatic refusal to continue with past agreements on structural measures would end up having the same effect. It’s worth wargaming out what the various parties might be thinking and how their strategies might interact…

Sappho: Why has that man covered himself with blue paint?

Atticus: We are here not to have a Socratic debate, but to watch one.

Axiothea: And our role is to be a more-or-less MST3K to the situation?

Atticus: Less rude, and more informative. We will see how it develops.

Aristokles: Who put you in charge?

Atticus: That I own the time machine? That even though most of you know me only as the guy whom my friend Marcus Tullius Cicero ranted and vented to, and even though I spent a huge amount of my time trying to keep Cicero from getting himself killed either by his political enemies or by my sister, I did have a day job: I am a banker. This is my territory.

Thrasymakhos: Hush. A second interlocutor approaches.

Barry Eichengreen: The decision to join the Eurozone is effectively irreversible. The insurmountable obstacle to exit is procedural. Reintroducing the national currency would have to be preceded by very extensive discussion. In 1998, the founding members of the Eurozone agreed to lock their exchange rates at the then-prevailing levels to rule out depressing national currencies in order to steal a competitive advantage. In contrast, today the very motivation for leaving would be to change the parity. A system-wide bank run would follow. Investors anticipating that their claims on, say, the Italian government would be redenominated into lira would shift into claims on other Eurozone governments. It would be unlikely that the ECB would provide extensive lender-of-last-resort support. And the government would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises. What government invested in its own survival would contemplate this option? As soon as discussions of leaving the Eurozone become serious, it is those discussions, and not the area itself, that will end.

Glaukon: These people are long-winded.

Cnaeus Pompeius Magnus: Have people become more intelligent since our days? I remember how Marcus Porcius Cato, Cicero, and I agreed that we had Gaius Julius Caesar trapped–that for him to cross the Rubicon would be so disastrous as to be totally inconceivable. And so I wound up dead on a beach in Alexandria…

Hypatia: I know how that feels…

Sokrates: It is a disease of twenty-first century economists–that people will invariably walk down and examine the leaves of the game-theoretic strategy tree and so avoid disastrous branches. We see it often:

Daniel Davies: One thing it’s important to make clear is that the European policy makers aren’t stupid. I have lost count of the number of articles I’ve read where some opinion columnist or other acts as if the fact that Greece’s debt burden is unsustainable and cannot ever be repaid is some special insight available only to readers of his newspaper, and that the benighted fools of the Commission, ECB and Eurogroup are so ideologically blinkered that they can’t see this obvious fact. Often enough, this piece of pontificating is attached to some distinctly dodgy theorising about the peculiar national characteristics of ‘Germans’. The fact is, everyone knows that the total burden of Greek debt is too big to be serviced by the Greek GDP, and that if it isn’t written down, then Greece will always be reliant on an increasing stream of official financing to meet its roll-overs. Everyone also knows, although some of them might not be ready to admit it to themselves, that an indefinite commitment to financing the roll-over of an ever increasing debt burden is a fiscal transfer in all but name. The thing is, though, while the Eurosystem bureaucrats know this at least as well as anyone else, they have jobs in which they can’t simply bemoan the fact in print, then submit their copy and go off to think about something else.

Socrates: There, for example.

Axiothea: But not all of them:

Paul Krugman: Daniel Davies tells us that ‘European policy makers aren’t stupid.’ But they do say stupid things, still talking about expansionary austerity, still treating debt as a purely moral issue. Can and will they be realistic, accept that they can’t extract blood from a stone–at any rate not at the rate of 4.5 percent of [annual] GDP [per year]–in time to avert a spiral into disaster?

Axiothea: See?

Atticus: And Krugman believes we need to focus on the essentials:

Paul Krugman: Markets are panicking. It’s important to understand that this is not a verdict on the new Greek government, or at any rate only the new Greek government; it’s a judgment that the risk of no agreement, and a disorderly breakdown of the whole process, is high. I think it’s important to be as clear as we can about the stakes and the real interests here, lest players stumble into a disaster they could and should have avoided…

Aristokles: I am lost.

Atticus: Let’s back up:

Daniel Davies: Don’t think of the Greek debt burden, either in cash € terms or as a ratio to GDP, as an economic quantity. It isn’t an economically meaningful number any more. It is a political quantity–the means by which control is exercised over the Greek budget by the Eurosystem. The regular rituals are the way in which the solvent Euroland nations exercise the kind of political control that they feel they need to have if they are going to be fiscally responsible for the bills.

Aristokles: Can we go over that again?

Daniel Davies: Consider a young man–to make it concrete, let’s call him Jim–who is living rather beyond his means–every month, he has income of £5000 and expenses of £5500. He is maxed out on his credit card with £5,000 of debt. So his only source of funding is Aunt Agatha. Aunt Agatha makes Jim sign an IOU and pay interest, but the interest rate is pretty low compared to the credit card, and every time the debt comes due, she is content to extend the term and roll it over into a new loan. Jim has, over the last few years, amassed a balance of £50,000 in debt to his beloved aunt. Then disaster strikes and Jim’s income falls to £3000 a month. Aunt Agatha is prepared to increased her monthly loans from £500 to £2500, but she has a number of firm conditions attached. Some of these are things that Jim has been planning anyway, but some of them–like giving up on his foreign language course–seem counterproductive to him and he doesn’t really want to do them. What should he do? I hope everyone can see that the following piece of advice would be dreadful:

Well, the problem is your debt/income ratio, which is now around 153%. And Aunt Agatha is by far your biggest creditor. Tell her that you can’t pay her back and need her to write off half of your debt.

Thrasymakhos: Why is he named “Jim” rather than “Bertie Wooster”?

Glaukon: To explicitly compare Greece, its voters, and its politicians to a P.G. Wodehouse character would attract the scrutiny of the United Nations High Commissioner for Human Rights.

Aristokles: Why is it such bad advice, again?

Daniel Davies: Aunt Agatha is a very unusual kind of creditor. She is lending, at concessional rates, in circumstances where no other lender would be prepared to, and most importantly, she is the sole provider of finance to cover Jim’s deficit. If his relationship with her breaks down, he has no other sources of funding and would have to reduce his consumption, immediately, to equal his income…

Aristokles: So writing down the Greek debt actually makes Greece poorer because it comes at the cost of the end of current transfers to Greece?

Hypatia: Actually, I don’t think that is true…

Paul Krugman: The question is how much Greece will transfer to its creditors by running primary surpluses–and yes, at this point that’s the question, there’s no possibility that the creditors will transfer more resources to Greece. If Greece were to adhere totally to the previous terms, over the next five years it would make resource transfers of about 20 percent of one year’s GDP. From the point of view of the creditors, that’s a trivial sum. From the point of the Greeks, however, it’s crucial; the difference between a primary surplus of 4.5 percent of GDP and, say, 1.5 percent of GDP for the Greek economy and the welfare of its citizens is huge. There was modest de facto aid to Greece in 2010-2012, but no aid is currently flowing, nor will it.

Axiothea: Davies does admit that that word-picture was the past, not the present:

Daniel Davies: Things have moved on a bit. Jim gave in to Aunt Agatha’s demands and has stabilised his monthly situation, with income of £3500 and expenditure of £3500. But he has an interest bill on his credit card of £100 every month so he still needs to borrow a bit from Aunt Agatha. And he has got a new girlfriend who keeps telling him that he really ought to start the language course again if he is going to have any prospects. This is Greece now. Primary balance has been achieved and growth is positive again. Syriza wants to make more investment spending. But it seems clear to me that the following strategy is not going to help Jim.

If you stopped paying interest on Aunt Agatha’s IOUs and told her to write off half your debt, you could afford to take those language courses again.

Aristokles: Why not?

Daniel Davies: Because it’s not true–messing around with the debt interest on the EU debt doesn’t free up any material resources for the Greek state budget, unless the EU can be persuaded to advance more money. If you can persuade the EU to finance some deficit spending, then the problem is already solved. Negotiating with Aunt Agatha about the language course would be a sensible course of action, but not kicking off those negotiations with a load of demands that her to confront the reality that she is throwing good money after bad.

Thrasymakhos: So Greece should shape its negotiating strategy to avoid hurting the German government’s feelings?

Sokrates: I agree it does not fit with Davies’s earlier description of European policymakers as flint-eyed Machiavellian realists who do not let empty verbiage and meaningless accounting entries distract them.

Axiothea: But even that is wrong!

Paul Krugman: As both Daniel Davies and James Galbraith point out, at this point Greek debt, measured as a stock, is not a very meaningful number. The debt is an accounting fiction: whatever the governments trying to dictate terms to Greece decide to say it is. Focus on the aspect of the situation that isn’t a matter of definitions: Greece’s primary surplus, the difference between what it takes in via taxes and what it spends on things other than interest, the amount Greece is actually paying, in the form of real resources, to its creditors. Greece has been running a primary surplus since 2013, and according to its agreements with the troika it’s supposed to run a surplus of 4.5 percent of GDP for many years to come…

Atticus: The focus on real resource transfers is a very important point. And Davies does recognize that looking forward:

Daniel Davies: The EU program for Greece assumes large primary surpluses for the years 2016–2020. And that changes the dynamics significantly. In a couple of years’ time, Jim’s income has reached £4000 a month, but his expenditure is still £3500, per Aunt Agatha’s original budget. He’s paying down his credit card, and he really really wants to get back on that language course. At this point, the “Tell Aunt Agatha to get stuffed” advice is… well, I still wouldn’t regard it as prudent, even if one ignores the morality of short-changing a beloved aunt. But it’s no longer actively suicidal. If the language course helps Jim get a high flying job elsewhere, then it could kick-start his comeback to a state where he can pay all his debts and persuade the fair Cecilia to marry him. If Syriza think that diverting [future primary] surpluses into fiscal stimulus could kick-start a recovery, then it would make sense to ignore the troika and start playing real hardball.

Glaukon: “Cecilia”? “Caecilia”? Is someone going to run off with your mother, Atticus?

Sokrates: No, it’s just that the appearance of that name in Daniel Davies’s piece was what triggered this off. But that “beloved aunt” stuff–once again it doesn’t quite seem to fit the rhetorical pose of the down-to-earth Welshman who doesn’t trust flowery motives…

Glaukon: And what Daniel Davies sees as the future, in which Syriza might change its negotiating strategy without catastrophe, Paul Krugman sees as the present. For Paul, now is the time to figure out what to do with Greece’s 2015-2020 primary surpluses…

Atticus: There is a point to it:

Daniel Davies: I wouldn’t advise this though, for one very good reason, which the more cynical readers and afficionados of PG Wodehouse novels may already have skipped ahead to… One day, Aunt Agatha is going to die. When she does, it’s very likely that her will is going to release Jim from his IOUs; although she is much too straight-laced and Calvinist to admit any such awful thought. Wouldn’t it be a terrible shame to shut yourself off from such a generous aunt, particularly as the rosy future on the language course is far from assured? One day, fiscal union will happen in the EU and Greece’s debts will disappear into a common pool. Everyone knows this, but it’s not politically acceptable to say so at present. Given that, it makes little sense to risk the relationship for a short term gain. Syriza has a much more appealing strategy in a negotiated settlement, involving less primary surplus and more stimulus spending.

Thrasymakhos: Now I am lost. It seems to me that Daniel Davies is saying that the fact that even though the Euro Troika has done the wrong thing over the past seven years Syriza should still avoid trying to play hardball because the Troika are going to do the right thing in the future, any day now. I do not see where that confidence comes from.

Hypatia: Say, rather, that Daniel Davies believes that being inside the charmed circle of the European Union as a member in good standing is going to be an enormous source of wealth for Greece over the next two generations:

Daniel Davies: Seeing the peripheral Eurozone debt in isolation from the politics of European integration is a sure way to lead yourself up blind alleys. It is, therefore, totally inimical to the Eurosystem to hold out any hope of the kind of debt writedown that Syriza wants. Syriza wants to get a major up-front reduction in the debt number is to create political space to execute the rest of their program. The people who don’t understand it are the ones writing editorials in the business press which support the debt reduction but don’t think that Syriza should be given carte blanche to do everything it wants.

Hypatia: In Daniel Davies’s mind, not calling for a large writedown of Greece’s formal debt is a way for Greece to demonstrate that it is playing by the rules in the game of European unification–and that it is in Greece’s long-run interest to do so:

Daniel Davies: There’s more than a couple of Germans I’ve spoken to over the last few years who have pointed out that although Germany got massive debt relief in the twentieth century, it got it in the context of an equally massive national admission that the entire political system was rotten and needed to be totally restructured with foreign help.

Thrasymakhos: But the cost of playing by the rules and running large primary budget surpluses over the next six years as long as Germany keeps ECB monetary policy inappropriately tight is absolutely enormous:

Paul Krugman: Relax[ing] that [primary surplus] target would not mean demanding that creditors throw good money after bad; everyone has already implicitly acknowledged that the debt will never be fully paid. [If] Greece stopped running a primary surplus at all, you might think that this would let the Greeks spend an additional 4.5 percent of GDP–but the benefits to Greece would actually be much bigger. The extra spending would mean a stronger economy, which means more revenue. Suppose that the multiplier is 1.3 and that Greece can collect 40 percent of a rise in GDP in revenue. Then an additional billion euros in spending should generate around 0.5 billion euros in revenue, reducing the primary surplus by only 0.5 billion euros. Dropping the requirement that Greece run a primary surplus of 4.5 percent of GDP would allow spending to rise by 9 percent of GDP and raise GDP by 12 percent relative to what it would have been otherwise. Unemployment would fall by around 10 percentage points relative to no relief. The question of how large a primary surplus Greece runs is real and has powerful implications for the economic outlook. Keep your eyes on that ball.

Thrasymakhos: Can Aunt Agatha’s will be generous enough to make up for that!?

Atticus: You got me.

Sokrates: There are dangers for the rest of Europe from walking down the no-resolution branches of this strategy tree as well:

Paul Krugman: The consequences of playing hardball with Greece over its banks could very easily be immense. Up until now, the euro has proved very durable, largely thanks to the point Barry Eichengreen emphasized: any country that even hinted at the possibility of leaving would face the mother of all bank runs. But as I worried some time ago, this argument becomes moot if the banking system has already collapsed. If it turns out that the single currency is not irreversible, do you really think there would be no contagion? At the moment, Germany is talking as if it intends to follow the Michael Corleone strategy. But do we really think that Syriza will or even can retreat with its tail between its legs immediately after winning a dramatic election victory? Again, wanna bet on it? Wanna bet on it?

Atticus: Daniel Davies really disagrees:
Daniel Davies: Tsipras’ strategy is… cute. I think it might even have worked if tried three years ago; as far as I can tell, something like it was the unspoken threat under the table which led to the restructuring of the Irish bailout liability. It’s a blackmail game that is best played by a left-wing populist, because in order for the threat to be credible, it needs to be made by someone who is not susceptible to apocalyptic warnings and who is even prepared to dice with the prospect of actual bank runs. I can entirely see why it’s attractive to Syriza and Tsipras. But this isn’t three years ago. I think that if faced with this sort of behaviour by a Syriza government, the ECB would definitely decide to call the bluff. Euroland had a real, credible stress test and it wasn’t the one that we were all looking at. The real stress test in 2014 was the restructuring of Banco Espirito Santo. Stress tests are not a test of the banking system; they’re a test of the bailout system. The purpose of a stress test isn’t to bore the pants off us with megabytes of accounting data telling us things we already knew. The purpose is always to put the weakest banks in the system into a position where they need to be recapitalised, and thereby to demonstrate that the system is capable of dealing with capital shortages, and doing so without an unreasonable fiscal burden. The quick and brutal treatment of BES demonstrated that even in a comparatively large European bank, and even in one of peripheral Europe’s shakiest fiscal systems, it was possible to carry out a refinancing and resolution over a weekend, with legal certainty and without contagion to other banks or interruption of vital services. The successful outcome from BES must surely encourage the Eurosystem policy makers to think that Greek euro exit, if it happens, could be contained…

Thrasymakhos: So how is all this likely to end?

Atticus: Let’s listen:

Daniel Davies: Syriza plays the ‘madman strategy’ and gets given meaningful concessions to keep it in the Euro. One would expect this to be associated with a lot of self-congratulation from the ECB and repetition of ‘whatever it takes’ speeches, and the end result would be to either monetise or mutualise a load of the Greek debt burden. This would be very bullish.

Hypatia: That would seem to be the usual way that Eurozone crises have been dealt with over the past seven years…

Sokrates: Although very inadequately, from the standpoint of recovery of employment. Good for banks and capital holders, not so good for…

Atticus: Hush!

Daniel Davies: If Syriza plays the ‘madman strategy’ and Greece leaves the euro, this would be the mother of all buying opportunities as it would surely be associated with a massive risk-off trade, but the market would be quick to subsequently realise that the actual effect on the Eurozone was heavily quarantined.

Hypatia: And then?

Thrasymakhos: Davies’s implicit view is that Greece is then in trouble–cast out of the European Union into the status of a Belarus or a Turkey or an Algeria–and loses big long-term…

Sokrates: But the Eurozone recovers..

Atticus: Hush!

Daniel Davies: So my view is, I guess, that if you can close your eyes and open them again in January 2016, you buy Eurozone risk and hold it. The best trading strategy would be to keep some powder dry. Mon-Greek peripheral credit looks like it could be cheap, and potentially a way of parking cash somewhere without equity downside but some share in the upside when things get resolved and the market snaps back.

The Rebalancing Challenge###

J. Bradford DeLong :: U.C. Berkeley

OëNB Conference on European Economic Integration :: Vienna :: November 24-25, 2014

https://www.icloud.com/pages/AwBUCAESEHBN_GdfxLmukcgoyRX8ocAaKQdtWwIUBlPWhv0VX8vnODUjfjWOIbeFuUiF3QHyfCeMY9RUd2SgjBXFMCUCAQEEIKm3f8UIYBcEElisfxX1c6APGaWyaYQnStJfTZ2VtGVZ#2015-01-28b–DeLong_Rebalancing_Challenge_in_Europe.pages

There is an important purpose of an opening keynote talk like this one. Its task is to start from first principles and then give a large-scale bird’s-eye overview to what is to come. We have panels to come on monetary policy, balance-sheet adjustment and growth, inequality and its role in generating internal macroeconomic imbalances, external macroeconomic rebalancing, and banking sector regulation. They all presuppose that Europe, and within it the regions of Central, Eastern, and Southeastern Europe that we focus on here, need not just higher aggregate demand in the short-term but more. They need large-scale sectoral rebalancing. And that sectoral rebalancing needs to be rapid. Why? Because these economies will not grow smoothly without deep structural reforms–in these reforms need to be not just at the bottom but at the top, reforms of institutions, governance structures, and regulatory practices and mandates need to be carried out as well.

Note that the need, while urgent in Central Europe, Eastern Europe, and Southeastern Europe, is not by any means more urgent here then in the other regions of Europe.

So why is more than higher aggregate demand right now what is needed? And which of the many things that go under the labels of “rebalancing” and “structural adjustment” are most needed? And why?

If in the next half-hour I can answer these questions convincingly then there will be an intellectual framework into which the rest of the conference’s pieces will fit naturally, and we will all go back to our day jobs with a firmer grasp of the rebalancing challenge in Central, Eastern, and Southeastern Europe.

Thus let me try to place the rest of today in its proper perspectives.

The first perspective to take is the very long-run perspective.

Let me note three dates: September 12, 1683; June 18, 1815; and November 19, 1942.

September 12, 1683 was, of course, the end of the Turkish imperial project. It was the date of the last truly mass slaughter right here. On that day the defending armies commanded by Ernst Rüdiger von Starhemberg, reinforced by the relieving forces of King John III Sobieski of Poland, defeated and forced the retreat down the Danube Valley of the armies commanded by Grand Vizier Merzifonlu Kara Mustafa Pasha.¹ That was the last time that this segment, at least, of the Danube Valley saw the chaos, destruction, and death of large-scale long-lasting war. If von Starhemberg and Mustafa Pasha could see Southeastern Europe now, while they might mourn the loss of power of the dynasties they served, they would both be very pleased at the state of the people who live her–and both be very grateful that the peoples and states are, for the most part, not still locked in what looked then like an eternal region-encompassing destructive war of intolerant, militant faiths.

June 18, 1815 was, of course, the end of the French revolutonary-imperial project with the final defeat at Waterloo in Belgium of the army of the French Emperor Napoleon I Bonaparte by British, Dutch, and German forces under the command of the Irish-born Arthur Wellesley, Duke of Wellington. We all do owe a great deal to the implementation and then transmission of the good ideals of the Enlightenment by the French Revolution. We owe less than zero to the habit of deadly ideological purges introduced by the Convention in Paris and in the Vendee. And the practice of introducing and maintaining those ideals by every four years having a French army come through, burning as it went and living off the land, leaving famine in its wake, is something we can live without.² If either Metternich or Talleyrand could see right now that we are now longer engaged in the military destruction of the struggle for French dominance over Europe that consumed the sixteenth, seventeenth, and eighteenth centuries and that seemed to them to be perpetual, they would be pleased.

And November 19, 1942 was, of course, the end of the Nazi imperial project with the initial breakthrough of the Soviet Union’s Red Army at Stalingrad on the Volga.³ It was followed by two-and-a-half more years of fire, blood, and death, and then a process of reconstruction that hang in the balance in Western Europe for a decade and is still not complete in Eastern Europe. Nevertheless, if those whose job it was to start rebuilding in 1945, if the Adenauers and de Gaulles could see us now, they would be very pleased. Right now the European project is a success. And we could not have said that on September 12, 1683; on June 18, 1815; or on November 19, 1942.

In fact, we can take a much longer perspective in which the post-World War II project of European community, unification, and peace has been a success. It was not far from here that the tribes of the Kimbri and the Teutones who had left their previous homes somewhere in or near Jutland crossed the Danube River into Noricum in 113 BC.

Was it 111 BC that the Kimbri and the Teutones, having moved down from Jutland to what is now Austria and crossed the Danube, decided they would rather cross the Rhine into the land of feta and olives in the Rhone Valley rather than eat Sauerkraut and sausage–or, back then, probably auroch jerky–in Noricum, near what is now Salzburg? So they went. And so they looted, burned, ravaged, killed, and ruled until a decade later they were broken at the battles of Aquae Sextiae and Vercellae by the new-model Roman Republican army commanded by Gaius Marius C. f. seven times consul.⁴ Ever since then, by my count, it is every thirty-seven years that a hostile army crosses the Rhine going one way or the other bringing fire and sword. The original Swiss–the Helvetii. Julius Caesar. All of those who claimed to be Julius Caesar’s adoptive descendants. The Visigoths heading for Andalusia. Louis XIV commanding his armies to make sure that nothing grows in the Rhinish Palatinate so that his armies attacking Holland have a secure right flank. And, last, Remagen bridge in 1945. Every thirty-seven years, with increasing destructiveness as time passes.

Thirty-seven years after 1945 carries us to 1982. Thirty-seven years after 1982 will carry us to 2019. By 2019 we will have missed two of our appointments with slaughter. Even with Stalin’s legacy, the difficulties of post-Cold War transition, everything that has happened in the republics of the Former Yugoslavia, and the current struggle over austerity and adjustment between the northern and southern pieces of the Eurozone, things have gone very well indeed recently.

Yet, I believe, most think that we desperately need political union in Europe as insurance to keep the bad old days from 111 BC to 1945 from coming again. We do not want Europe to once again fall victim to the tragedy of great power politics⁵. That means that politicians find some way to union–so that differences are thrashed out in conference rooms in Brussels and Strasbourg rather than in the streets with Molotov cocktails, submachine guns, armed drones, and worse. That is the necessity.

This does not mean that we should minimize Europe’s current problems, just note that the problems are not as large as the achievements. The problems facing us are many. A very quick list consists of five. There are two major political problems:

• Incorporating ex-superpowers into the common European home–a problem Europe has faced over and over again since 1600, first with Spain, then with France after 1815, then with Germany after 1870, and now with Great Russia.
• Building institutions for continental governance in our late-Westphalian nationalist age.

And there are three major economic problems and opportunities:

• Grasping rather than letting drop the enormous fruits of continent-scale economic integration that nearly all studies of economies of scale and economic integration say are there.
• Accelerating the painfully and disappointingly slow convergence of both east and south to northwest European standards. Looking at the Asian Pacific Rim reveals that if we can get the institutions, the trade patterns, and integration more than half-right we can look forward to a régime of convergence in which living standards and productivity levels in a region converge halfway to the standards of that region’s core in a generation. We can do it. We have done it elsewhere in the past. We should be doing it now in Central, Eastern, and Southeastern Europe. And, frustratingly, we are not: it is more the slow-boring-of-hard-boards than it is the thirty-glorious-years.
• Successfully resolving and recovering from the shock of 2008 and its aftereffects. This is, mostly, what concerns us today. The other four problems are, mostly, in the background right now.

And the need is to do all of this in a global context that is not terribly supportive.

The global context of 2008 is a world that was characterized either by a global savings glut⁶ or a global investment shortfall, depending on which blade of the scissors is your favorite to focus on. That imbalance in turn produced either what one might call a global overleveraging: the gap between desired global savings at global full employment and planned global investment at global full employment was filled-in by credit creation to create funding for long-term investment projects that was not backed by savings commitments to long-run patient capital.⁷ One might, alternatively, call it a global shortage of risk tolerance: the gap between desired global savings at global full employment and planned global investment at global full employment was filled-in by promising savers that they were not bearing large amounts of systemic business-cycle risk when they in fact were.⁸ These are alternative ways of labeling the same underlying economic failure of expectations to be consistent that focus on somewhat different things–the apocryphal tale of the five wise men and the elephant comes to mind.⁹

We had a world in which there was no global hegemon, in a Keynes-Kindleberger sense, in Washington, willing to take responsibility for managing the level of global aggregate demand, even if the consequences for the domestic United States were potentially unfortunate.¹⁰ If in the 1950s and 1960s the U.S. under Bretton Woods had made a durable commitment to serve as the world’s importer of last resort, its falling into the same role during what some called Bretton Woods II was contingent and evanescent.¹¹

Moreover, we had a world in which there was no alternative local continental-scale orchestra-conductor focused on balancing effective demand to potential supply over the European continent as a whole. Instead, there were many countries, some of them very large, most of them focused inward, none of them thinking that responsibility needed to be taken. That, it was thought, ws the business of the European Central Bank, which had the proper monetarist tools to do the job of managing continent-wide demand. But what if those tools proved insufficient? The ECB did not have the power, and nobody had the power to do banking regulatory or fiscal policy in Europe on the proper continent-wide scale.¹²

Plus there was little sense in the years before 2008 of what a North Atlantic-wide Keynes-Kindleberger international economic hegemon would actually do. Such are used to dealing with problems of excessive aggregate demand, de-anchoring inflation expectations, and upward price spirals on the one hand; or with problems of liquidity shortage on the other. But we did not have a liquidity shortage–certainly not after the start of 2009. The monetarist playbook for how the Great Depression ought to have been handled was taken down from the shelf, dusted off, and applied.¹³ As a result the North Atlantic economy floated on an absolute sea of liquidity from the start of 2009 to the present day: so much has there been not-a-shortage-of-cash that central bank deposit velocity has fallen to low levels that I, at least, never thought I would ever see.

We have, instead, since the middle of 2008 had another kind of deficiency in the macroeconomy: aggregate demand has fallen below potential supply because there has been an excess demand for and a shortage of safe assets in the North Atlantic economy. That has been a consequence of an excess of risky assets, of an excess of nonperforming loans, of the transformation of assets formerly seen as safe into risky status. These problems are more sophisticated and less tractable to monetary interventions. Open-market operations that simply swap one interest-paying, or potentially interest-paying government liability with duration for a non-interest paying government liability with zero duration have next to no effect on the supply-and-demand for safe assets as a class.¹⁴

If we view the big shock of 2008 as a collapse on the demand side of risk tolerance and on the supply side as the recognition that very large classes of assets sold as safe were in fact not safe, one driven by events in the United States, then we would think that this collapse is both good and bad. It is good in that savers are no longer easily fooled: people who are in fact bearing systemic business cycle and other forms of risk are now aware that they are doing so, and if full employment is reattained it will not be under the shadow of expectations that are inconsistent and cannot be fulfilled. Creditors will not let debtors borrow and borrow and borrow until not only their solvency but the creditors’ solvency is at risk as well. It is bad because attaining anything close to full employment in a capitalist market economy requires that savers bear risk. The provision of risk-bearing capacity is an important factor of production that only those who have current wealth–are savers–can provide. And right now they are not doing so on a sufficient scale.

I was told this morning (November 24, 2014) that the ten-year Spanish government-bond nominal interest rate is now less than 2%/year. Whatever we think of those of you and of our friends who invest in Spanish government bonds, 2%/year nominal for ten years in euros does seem a little low given the existence of a great deal of value in the world today in the form of potentially-storable commodities, and given the existence of political uncertainties–black swans–over the net decade that are not things we can today quantify or even imagine. Compare a sub-1%/year German 10-year nominal bond rate to the 6%/year real earnings yield on a diversified portfolio of equities of European non-financial operating companies. With a 2%/year inflation target, 6+2-1 = 7. 7%/year is a huge premium return to get on equity investments in a diversified portfolio of corporations rather than government bonds subject to inflation risk–especially when one reflects that this is not a duration risk, for dividends plus stock buybacks today make up a very healthy cash payout, and the covariance of interest rates and corporate profits further reduces the effective duration of equities.¹⁵

That suggests that the collapse of risk tolerance has gone much, much too far. Right now we are in a world in which savers do not view the risks and opportunities of the world with clear eyes, but rather with eyes that perceive through a distorted negative bubble. Financial markets thus seem to be failing on a very large scale to successfully mobilize the risk tolerance of economies. This is doubly unfortunate. To undertake new enterprise or to invest to produce economic growth requires that someone peer through the veil of time and ignorance. That means that somebody must provide the risk-bearing capacity, must be willing to eat the losses if something goes wrong.

Back in 2008 we thought–I thought–I gave many speeches about how we were experiencing a shock that boosted demand for safe liquid savings vehicles, and that this shock was going to trigger a sharp downturn in the North Atlantic economies. But, I thought and said, the downturn would be short. At first, I thought it was going to just be a liquidity squeeze–and we knew how to deal with liquidity squeezes by using open-market operations to boost the money supply. Then it became clear that it was more than a liquidity squeeze. Yet even though it was not a liquidity crisis–even though taking down, dusting off, and applying the monetarist depression-fighting playbook would not be sufficient–the examples of the Great Depression and of Japan since 1990 would provide a guide for what not to do. So, I believed and I said, the North Atlantic would quickly resolve insolvent institutions and write down unpayable debts. The recession would be sharp. But recovery would be rapid. And afterwards the global economy would have been reknit into much the same pattern it was in before 2008.

This was wrong.

We have not reknit the global economy into the same pattern. We have not restored the long-run growth path that the North Atlantic was on before 2007. After a liquidity squeeze is brought to an end, asset prices return to normal, the sea becomes calm again, and, broadly, patterns of the societal division of labor that were profitable before the squeeze are profitable again. Hence all that needs to be done to reattain full employment is to reknit the same division of labor.

Not true this time.

This time, because there has been no recovery of risk tolerance–whether because of incomplete deleveraging, or the inability to reattain levels of risk tolerance that turned out ex post to be absurd but that nevertheless those engaged in enterprise required and expected, or for other reasons. Since there has been no recovery of risk tolerance, the previous division of labor across Europe cannot be profitably and sustainably reknit. There must be “structural adjustment” before anything like full employment can be reattained.¹⁶

Now nobody thinks that there ought to be a full recovery of risk tolerance to its levels in the days when a simple demonstration involving mark-to-model finance would convince a rating agency that a security deserved AAA, with which it could then be marketed at a spread of less than 25 basis points over the debt of credit-worthy sovereigns like Germany.

The pre-2008 European convergence equilibrium employed peripheral labor in Eastern, South Eastern, and Southern Europe in extremely risky long-duration enterprises: bets on the value of long-lived construction, bets that governments would resolve unresolvable public finance problems, bets that human capital would emerge to make profitable enterprises that would use new infrastructure. All of these bets seemed reasonable because risk tolerance was high. And perhaps most of them were reasonable–in the context of permanently-high risk tolerance. Hence the strong demand pushed relative real wages in peripheral Europe high relative to the regions’ relative productivity at producing tradable goods.¹⁷

All this came to an end in 2008.

Now, in order to properly rebalance–even though rebalancing has been ongoing for six years–peripheral workers in Europe must either boost their productivity in making tradable goods or find something safe to do, must find something that does not require the mobilization of any substantial amount of European core risk tolerance in order to make the financing work, or must accept large real wages declines. These are the options. If it were not for the existence of the eurozone, all or nearly all peripheral European economies would choose the third: real wage reduction via depreciation of the currency. But for many that is not an option, or not a good option, or not seen right now as the best of the bad options. Peripheral depreciation for countries not in the eurozone and peripheral internal deflation for countries that are may in the end be the road chosen, in spite of all the economic pain and chaos it is generating now and will generate in the future. Euro-core inflation–“structural adjustment” in the northern core rather than in the periphery–is another possibility. Real “structural reforms” that successfully and substantially boost productivity in making tradable goods would be an option, if that unicorn could be found.

The problem is that “structural reform” too often stands as a placeholder for all good things that would increase an economy’s productivity. The danger is that when commitments to “structural reform” are not accompanied by any political economy strategy to successfully disrupt the current stakeholders blocking reforms in order to confiscate their current rents.

Attempting to restore financial-market risk tolerance–but, we hope, not to go-go levels–is another possible strategy. A 7%/year gap between the returns to properly-diversified real European equity baskets and the returns to lending money to the German government could be greatly lessened without, in my judgment, running any risk of a new round of bubble finance. There is using the governments’ powers to tax to mobilize the risk-bearing capacity of Europeans continent-wide–but if taxpayers are bearing the risk they deserve the returns of enterprise as well, and history had not been kind to those who think that governments’ interventions in industry can take the form of a very large and high-return investment portfolio. Better, probably, for the government to boost the supply of safe assets via deferring the taxation to ultimately amortize expenditures it ought to be undertaking anyway than to involve governments on a larger scale as venture capitalists and industrial financiers.

This would be the case even were there not the additional problem that the risk-bearing capacity of taxpayers is mostly in the core of Europe, while the need for additional demand right now is mostly on the periphery. In the United States we do not track economic flows between states as Europe tracks flows between nations. We do not assign our national debt to individual states. We do not have to worry about this. In the United States back in 1991-2 after the collapse of the Savings and Loan bubble the United States central government transferred to Texas a sum equal to 25% of a year’s Texas GDP–an amazing no-strings bailout–without there being any complaint or worry about fiscal transfers or about encouraging a feckless culture of moral hazard in rattlesnake country. Part of it was that we did not notice. Part of it was that the senior senator from Texas was in the key position of being Chair of the Senate Finance Committee. Europe cannot do the equivalent, or anything close, without political upset.

Or else?

If structural reform and demand management are not both successfully performed, the alternative for Europe is then a long and uneven depression. Such might produce political pressures to set European economic integration into reverse. That, however, is a low-probability scenario. The higher-probability scenario in the event of the failure of structural reform and demand management is for European union and the euro to be held together by, year after year, just enough fiscal transfers and debt relief from the core to keep the grinding pain of deflation in the euro periphery from becoming so great as to trigger reversal. This would, in the end, be a much more expensive strategy for the core’s than taxpayers than one of biting the bullet and immediate resolution and debt writedown.

What can we say about the roads toward structural adjustment–toward an economic configuration that could sustain continent-wide full employment without relying on unreasonable expectations of risk and return?

For some countries, exchange rate policy is possible. Exchange-rate policy is very effective medicine. It is a very good way of improving competitiveness and sharing social burdens. The problem is that it is such only as long as inflation expectations are anchored in domestic nominal terms. When they are not–especially when inflation expectations become anchored to inflation in import prices–relying on exchange rate depreciation is worse than useless. It is a medicine that is effective until resistance develops, and the fear is that alongside resistance there will also develop addiction to this mechanism. Hence it should be resorted to gingerly, lest overuse lead to high inflation and to even more intractable structural problems.

Nevertheless, if the largest global financial shock in a century is not a time to resort to it for those countries that can, when would the proper time to resort to it be?

But how can we know whether tolerance has developed? That is a question. I do not have an answer.

Within the eurozone, internal devaluation is not a possibility. External devaluation–chiefly vis-a-vis the dollar, hoping that the United States will once again be willing to take on the role of importer of last resort–is a possibility. However, it does not resolve Europe’s internal structural problems. What it does do is make life very pleasant for the export powerhouse that is Germany. And while life is pleasant for Germany, perhaps its politicians can be induced to make concessions and provide funding and take policy steps that do resolve Europe’s internal structural problems.

There is the possibility of replacing the missing private risk-tolerance for large-scale loan guarantees, asset purchases, or public spending to create demand for products that enterprises in peripheral regions can produce. That requires that European politicians know and understand and be willing to use the debt capacity of Europe’s core for the benefit of primarily the periphery but of the eurozone as a whole. There is “structural reform”, and the knotty question of whether structural reform is harder when unemployment is high or when it is low. Those in Frankfurt and Berlin are sure that structural reform can be accomplished only when unemployment is high and politicians feel a sense of crisis in their bones. Those in Washington are sure that structural reform can be accomplished only when unemployment is low and politicians can assemble fleshpots of resources to be distributed to assemble majority political coalitions. I avoid taking a stand on this issue by saying that I am just an economist. I do, however, note that the fact that at most one of these can be true does not mean that at least one of these is true.

And, as noted above, inflation in the European core and deflation in the European periphery round out the list. We have not had much of the first. We have had a lot of the second. A 2%/year inflation rate for the eurozone as a whole with a 0%/year inflation rate in the eurozone’s poorer half does mean 4%/year inflation in the eurozone’s richer half. I do not see how anything good could come out of a monetary target that turns into a mandate that inflation in the European core must always be less than 2%/year. Whether all who staff the ECB fully understand this is not clear.

But among all these possibilities, why choose? These all seem to me to be not substitutes but complements.

Yet the political economy of today in Europe seems curious: these are all, overwhelming, posed as either-or substitutes, as mutually-exclusive alternatives. And I hear the same thing in the United States as well. Yet I have never understood this. I have always thought that the best and obvious strategy is to attempt them all–and to be willing to, pragmatically, reverse course on those that appear to turn out to have implementation costs greater than their potential benefits.

I have been waiting for five years for somebody to tell me why what seems obvious and best to me is not obvious and best.

And I am still waiting.

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Over at Project Syndicate:

For a while the best book on the macroeconomic catastrophe that struck the North Atlantic starting in 2007 was Gary Gorton’s Slapped by the Invisible Hand. Them for a while the best book was Alan Blinder’s After the Music Stopped. Now these have been superseded by two: the extremely-observant sensible Tory Martin Wolf’s The Shifts and the Shocks; and my friend, patron, teacher, and (until the last reshuffle) office neighbor Barry Eichengreen ‘s Hall of Mirrors. Read and grasp the messages of both of these, and you are in the top 0.001% of the world in terms of understanding what has happened to us–and what the likely scenarios are for what comes next.

Consider, first, Martin Wolf’s The Shifts and the Shocks. Its spine is a masterful cataloguing of all the major shifts we have seen that set the stage for the disaster that hit the North Atlantic in 2007-9:

1. The huge rise in the wealth of the global 0.01% and 0.1%, with its consequent pressures for overleverage and demand volatility
2. The global savings glut, with more of the same pressures.
3. The “insouciance” toward the resulting risks generated by the intellectual victory of the rational-expectations and efficient-markets hypotheses.
4. The resulting deregulation, that made it easy to sell assets perceived to be safe that were not in fact so and to greatly multiply the systemic risk in the system beyond any central banker’s imagining.
5. The resulting policy-making climate, with the three-fold hubris of: (1) underestimating tail risks, (2) settling on a 2%/year inflation target that did not provide sufficient systemic risk sea-room, and (3) the greater hubris of the creation of the euro.
6. The continuation in which it apparently made sense in 2008 and since to do what was necessary but no more than necessary to handle the immediate crisis

In the context of these shifts, Martin Wolf sees immediate need in the short-run for policies to solve the immediate crisis: more spending, especially investment spending, by reserve-currency issuing sovereigns; more issue of high-quality debt to resolve the safe asset shortage by reserve-currency issuing sovereigns; and reserve-currency issuing central banks that monetize enough of this debt to raise the trend inflation rate from 2%/year to 3%/year or 4%/year. The argument seems, to me at least, to be convincing and unassailable.

But that is not all. Wolf’s book calls as well for medium run policies: (1) Either “break up… or… create a minimum set of institutions and policies” to make the euro work. And (2) the obvious but undone regulatory measures to greatly diminish leverage and the use of debt. And last come Wolf’s recommendations for the long-run: policies for more equal wealth; better economics less in thrall to rational-expectations and efficient-market ideologues; “more global regulation… and more freedom for individual countries to craft their own responses”. These seem to me to be obvious requirements on the situation.

But 2005-2014 did not create the pressures to do what Wolf and I see as the obvious things. Why not? And here is where Eichengreen’s Hall of Mirrors is most useful.

It tells the story of a historical process with five stages. The first is the intellectual victory within sensible economics of monetarist over old Keynesian and Minskyite interpretations of the Great Depression. The second is the resulting ability and willingness of governments to pull the monetarist policy package–what Milton Friedman had promised would have stopped the Great Depression in its tracks and erased its effects–off of the shelf and apply it in 2008-2009. The third is the very incomplete but also very real partial effectiveness of that package, for the monetarist interpretation of the Great Depression was, to put it baldy, wrong and radically incomplete. But it did enough good that a full-fledged repetition of the Great Depression was avoided.

And that led to the fourth stage: the declaration by governments of victory–of green shoots–of the successful resolution of a crisis–of a need to turn policies toward more important “structural” issues involving the necessity for “austerity” in the size of government. This fourth stage has been followed by the fifth in which we are now embedded: First, a very partial barely-a-recovery, one that is turning into a new normal in which the North Atlantic will turn out to have thrown away a full ten percent of all of what was its potential future wealth. Second, the failure to undertake the financial regulatory and economic governance reforms needed to diminish the chances of a repeat of the disaster in which we are still embedded.

Thus, Eichengreen concludes, partial success turns out to be global failure: immediate pain of a proportional magnitude equal to that of the Great Depression was avoided, but the potential for economic growth and successful macroeconomic stabilization in the North Atlantic going forward will be (because of failure to learn the lessons of 2000-2010 and make the obvious reforms) less post-2015 than it was post-1945, back when the lessons of 1925-1935 had been learned and the obvious reforms had been made.

Wolf sets out what we ought to have done. Eichengreen provides the narrative of the historical process which has led us not to do it.

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